There are about six basic financial derivative instruments or contracts which have evolved over the years. These are forwards, futures, swaps, options, rights and warrants.
It is common to find in business that buyers and sellers are subject to exactly opposite risks. The manufacturer of confectionery is concerned that the price of sugar may rise next year, while the sugar cane producer is concerned that the price may fall. In a world where it is extremely difficult to predict, with any real confidence, future commodity prices, both parties may want to exchange uncertain prices for sugar delivered next year for a fixed price.
There is a mutual benefit for the two parties to agree a price for sugar delivery next year and thereby hedge the price risk. The confectionery manufacturer hedges against prices escalating, while the sugar cane producer hedges against prices dropping. They do this by entering into a forward contract enabling future transactions and their price to be agreed today, but not to be paid for until delivery at a specified future date. Thus a forward contract involves the purchase or sale of a specific quantity of a commodity, security, foreign currency or other financial instrument at a price established at the time the transaction is effected (i.e. now), with delivery and payment to be made at a specified future date.
The major drawbacks in this type of transaction are:
(a) the presence of counterpart credit or performance risk:
(b) the difficulty in finding a trading partner;
(c) the fact that the transaction can usually only be completed with physical delivery or through a financial settlement with the original counterpart, rather than a simple sale of the obligation to any third party. Futures transactions have developed largely in recognition of these institutional deficiencies to forward contracts.
A futures contract is a forward contract that is traded on an organized exchange with contract terms specified by the rules of the exchange. The futures exchange provides standardized contract terms and guarantees performance on the contracts to both parties. Futures contracts call for delivery of some commodity at a specified later date at a price determined at time of entering the contract. Financial futures are futures contracts based on financial instruments.
The most commonly traded financial futures are those based on currencies, debt instruments and financial indexes. A financial futures developed out of the quest to overcome some of the drawbacks which have become associated with forward contracts.
Financial futures make it unnecessary for parties to contracts to know and trust each other as a basis for ensuring that underlying contractual obligations will be honored. The involvement of an organized exchange (as intermediary/custodian for settlements) mitigates against the strong incentive to default that may ordinarily be inherent in options or futures arrangements and therefore expands the prospects and scope of possible trades in futures instruments.
Financial futures also help to overcome the lack of liquidity that may apply to forward contracts deriving from difficulty involved in finding two parties with corresponding “take” and “dispose” needs that are essential to consummating contracts.
Financial futures also make it possible, through the instrumentalities of an organized exchange, for panics to contracts to fulfill their obligations without actual making or taking physical delivery of the underlying commodity (shares, debt stocks or foreign currencies involved) but by the payment of cash.
Futures markets have emerged to provide an institutional framework that copes with the identified deficiencies of forward contracts. The organized futures exchanges standardize contract terms and guaranty performance on contracts to both trading partners. Thus the features of traded contracts such as asset, date, size and delivery arrangements are specified by the exchanges. Hence the only feature of a futures contract that is determined at the time of the trade is the futures price. The exchange also provides a simple mechanism that allow traders to complete their obligations at any time.
An option is a contract in which the writer of the option grants the buyer of the option the right, but not the obligation, to purchase from or sell to the writer something at a specified price within a specified period of time (or at a specified date). The writer, also referred to as the seller, grants this right to the buyer in exchange for a certain sum of money, which is called the option price or option premium. The price at which the asset may be bought or sold is called the exercise or strike price. The date after which an option is void is called the expiration date.
When an option grants the buyer the right to purchase the designated instrument from the seller, it is referred to as a call option or call. When the option buyer has the right to sell the designated instrument to the writer, the option is called a put option or put. The buyer of any option is said to be long the option; the writer (seller) is said to be short the option.
An option is also categorized according to when the option buyer may exercise the option. An American Option may be exercised at any time up to and including the expiration date.
A European Option may be exercised only on the expiration date.
A swap is an agreement between two or more parties to exchange a set cash flows over a period in the future. The cash flows can be based on:
i) debt instruments, i.e. interest rate swaps; or
ii) foreign currencies, i.e. currency swaps.
A right is a short-term right to buy shares. It is usually specified in terms of the right to buy a given number of new shares in a company relative to the number of shares already held. For example, the right to buy one new share for every two already held. Internationally, rights are regarded as tradeable instruments and are widely traded since rights clearly have value. A right is indeed a variant of option.
A warrant is an instrument that confers a long-term right to buy the shares of a company. These instruments can be sold alone, but they are usually sold as “sweeteners” to debt or preferred shares offerings. Warrants have initial lives of about 3 to 10 years and the terms of the warrants are usually spelt out in a warrant agreement and administered by a trustee. The agreement contains details of such terms as exercise price, call price, anti-dilution protection, voting rights, etc. Warrant is also a variant of option.