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Swaps, Options, and Futures: What They Are and Their Function

Checklist

This checklist describes certain types of derivatives that can be traded on stock exchanges and how they function.

Definition

A swap is a derivative in which two parties agree to exchange a set of cash flows (or leg) for another set. A notional principal amount is used to calculate each cash flow; these are rarely exchanged by the parties. A swap is usually used to hedge a risk, such as an interest-rate risk, or to speculate on a price change. It may also be used to access an underlying asset in order to earn a profit or loss from any change in price while avoiding posting the notional amount in cash or collateral. An option is a financial instrument that gives the holder the right to engage in a future transaction on an underlying security or futures contract. The holder is under no obligation to exercise this right. There are two main types of option. A call option gives the holder the right to purchase a specified quantity of a security at a fixed price (the strike price) on or before the specified expiration date. A put option gives the holder the right to sell. If the holder chooses to exercise the option, the party who sold, or wrote, the option is obliged to fulfil the terms of the contract. Futures are traded on a futures exchange and represent an obligation to buy or sell a specified underlying instrument on a specified date (the delivery date or final settlement date) in the future at a specified price (the futures price). The settlement price is the price of the underlying asset on the delivery date. Both parties to a futures contract are legally bound to fulfil the contract on the delivery date. If the holder of a futures position wishes to exit their obligation before the delivery date, they must offset it either by selling a long position or buying back a short position. Such an action effectively closes the futures position and its contractual obligations.

Advantages

· The use of derivatives means that some financial risks can be transferred to other parties who are more willing or better suited to take or manage those risks and can thus be a useful tool for risk management. Purchasing derivatives can be a safer choice if there is a possibility of a looming bear market as they are hedged, unlike equities. Buying now at a future price can be cheaper than buying at market price in the future, bearing in mind that the spot price could be less expensive. A long call option requires no obligation when it is due.

· · ·

Disadvantages

· · If the market changes dramatically, it is possible to lose financially if the derivatives are being used as a speculative instrument. If you hold the put option on a derivative, you are obliged to adhere to it if the holder of the call chooses to exercise their right to sell or buy.

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Dos and Don'ts

Do

· · Take time to consider which derivative is most suitable for the transaction you have in mind. Consult a financial intermediary or seek other expert guidance if you are unsure.

Don't

· Don't enter into a contract that will lock you in if there's the slightest possibility that you may need to exit before its expiration date.

More Info

Books:

· Arditti, Fred D. Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and Mortgage Securities. Financial Management Association Survey and Synthesis Series. Boston, MA: Harvard Business School Press, 1996. Cox, John C., and Mark Rubinstein. Options Markets. Englewood Cliffs, NJ: Prentice Hall, 1985. Hull, John C. Options, Futures, and Other Derivatives. Prentice Hall Series in Finance. 7th ed. Upper Saddle River, NJ: Prentice Hall, 2008. Redhead, Keith. Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps. London: Prentice-Hall, 1996.

· · ·

Articles:

· · · · Black, Fischer, and Myron S. Scholes. "The pricing of options and corporate liabilities." Journal of Political Economy 81:3 (1973): 637­654. Cox, J. C., S. A. Ross, and M. Rubinstein. "Options pricing: a simplified approach." Journal of Financial Economics 7 (1979): 229­263. Moran, Matthew. "Risk-adjusted performance for derivatives-based indexes--Tools to help stabilize returns." Journal of Indexes (4th Quarter 2002): 34­40. Schneeweis, Thomas, and Richard Spurgin. "The benefits of index option-based strategies for institutional portfolios." Journal of Alternative Investments (Spring 2001): 44­52.

See Also

Best Practice · The Role of Short Sellers in the Marketplace Checklists · Derivatives Markets: Their Structure and Function · Hedge Funds: Understanding the Risks and Returns Finance Library · · Futures, Options, and Swaps Option Volatility and Pricing: Advanced Trading Strategies and Techniques

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