Types of Derivatives
Form # 1. Forward:
Forward contract is a transaction which binds a seller to deliver at a future date and the buyer to correspondingly accept a certain quantity of a specified commodity at the price agreed upon. Forwards are custom made contracts to buy or sell foreign exchange in the future at an agreed and specific price. Maturity and size of contracts can be determined individually to hedge the desired position.
Form # 2. Future:
Future contract is a standardized contract guaranteeing delivery of a certain quantity of a commodity or financial instruments on a specified future date, at the price agreed to, at the time of entering in to transaction.
Futures are a standardized contract to buy or sell foreign exchange in the future at a specific price, a firm buying a currency future is entitled to receive a specified amount in a specified currency for a stated price on a specified date in future on which the future contract is exercisable.
Hedging of future payables in terms of foreign currency, the firm who has to make payment in foreign currency may enter into currency futures contracts of the currency needed.
The future contract decides the amount of the home currency which the firm has to make in order to oblige its foreign currency payment on a future date, in case of foreign currency payables. In the case of foreign currency receivable, the steps to be taken by firm will be vis-a-vis. Through the future contract, the firm will protect itself from the fluctuations of the foreign exchange rate.
Form # 3. Option:
Option is a contract that gives the holder the right to buy or sell a certain number of commodities at a specified price known as ‘Striking Price’ or ‘Exercise Price’.
Options are contracts that confer the right, but not the obligation, to the option holder or buyer to take delivery or give delivery of foreign currency in the future at a specific price to the option seller or writer. Options are also being used by firm to hedge against contingent risks or liabilities.
A currency option hedge involves the adoption of currency call or put options to hedge transaction exposure. In case of the options, the option owner or option buyer has the option of exercising the contract. Thus, the option owner or buyer gets protected from the adverse exchange rate movements and may benefit from the favorable exchange rate movements.
Hence, limiting or minimizing the losses and providing a space for profits. The firm must assess whether the advantages are worth the premium to be paid for the option.
To hedge payables, firm will purchase a currency call option on the foreign currency which is payable. The firm can use the call option to buy the foreign currency at a specified price.
To hedge receivables, firm will purchase a currency put option for the foreign currency which firm will receive. The firm can use it to sell the foreign currency at a specified price.
When the quantity of a foreign-currency cash flow is known, forward or future contracts are better than options contracts. On the other hand, when the quantity of a foreign-currency cash flow is unknown, options contracts are better than forward or future contracts.
Form # 4. Swap:
Swap is the exchange of financial liabilities or assets which may be in the same currency or in different currencies. Swaps are contracts which involve two counter parties to exchange foreign currency over an agreed period. The swap of currencies of countries is known as currency swap.
In a currency swap contract, the either party of the exchange is committed to make the payments in different currencies to other party, over an agreed period. In currency swap different rate of interest are used. When the period of currency swap contract gets completed, the exchange of principal amount takes place, which is calculated as per the exchange rate as agreed at the time of entering into the contract.
Futures and options are being currently traded over many exchanges spread across the globe, actively. Different types of options, swaps, forward contracts, futures are being regularly traded among financial and banking industry and corporate through over the counter (OTC) markets.
The table 9.1 shows comparisons between forwards and futures: