Derivatives in general are divided into several categories, the most prominent being options, swaps, forwards and futures. This article explores similarities and differences between options on one side, and swaps, forwards and futures on the other.
Derivatives in general
Derivatives owe their popularity to a number of qualities that make them perfect for hedging (as in extra insurance against adverse market conditions), speculation or facilitating easier trade in terms of assets and markets that would be unavailable otherwise. What options and other derivatives have in common is that they are all types of contracts whose value is derived from the value of the underlying financial instrument or commodity. That instrument may be anything from indexes to assets to interest rates.
The value of an option is based on the value of the underlying stock or an equity – thus the name equity option. What holders of equity actually “hold” is the prerogative to buy or sell a specific stock, at a predefined quantity, in a predefined period of time, at a predefined price (or not to buy or sell it, if that is what they chose). Other types of derivatives are usually far more binding for all parties, especially for buyers.
Swaps involve the exchange of cash flows or other variables between parties involved; they are usually centered on currency or interest rate exchange. The best part of swaps is that they enable parties who operate under different conditions to turn their predicament into an advantage. This way a party in need of Euros (with a steady supply of dollars) could enter into a swap with another party which needs dollars (but can acquire Euros under more favorable conditions) to a mutual benefit. Getting out of a swap which turned out to be less favorable than expected can be a bit tricky, but not impossible.
Forwards and futures both enable their holders to acquire goods, assets or financial instruments at a predetermined price. Forward contracts are typically on a larger scale, mostly unregulated and usually require no down payment. Futures are standardized, more available and relatively safer, as they involve obligations for both parties (including down payment). Forwards typically involve currency trade, while futures tend to focus on commodities. Futures do not offer a lot in terms of versatility, due to their standardized nature. Forward contracts are considered private agreements and are therefore less prone to standards and regulations. They do tend to be exclusive, as high counterparty risk makes their users wary of outsiders and parties that are not of high standing.
Derivatives are a vital component of modern markets. Some people prefer trading without strings attached (at least on their part), so they go for options. Others prefer security of futures, versatility of forwards or the practical nature of swaps. There is a lot more to be said on each and every one of them, and it will – some other time.