Derivatives - Forward Contracts

A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees
to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at
a later time, but the price is determined at the time of purchase. Key features of forward
contracts are:

Highly customized - Counterparties can determine and define the terms and features
to fit their specific needs, including when delivery will take place and the exact
identity of the underlying asset.
All parties are exposed to counterparty default risk - This is the risk that the other
party may not make the required delivery or payment.
Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
Underlying assets can be a stocks, bonds, foreign currencies, commodities or some
combination thereof. The underlying asset could even be interest rates.
They tend to be held to maturity and have little or no market liquidity.
Any commitment between two parties to trade an asset in the future is a forward
contract.

Example: Forward Contracts

Let's assume that you have just taken up sailing and like it so well that you expect you might
buy your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to
upgrade to a newer, larger model in 12 months. You and John could enter into a forward
contract in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in
12 months for that price. In this scenario, as the buyer, you have entered a long forward
contract. Conversely, John, the seller will have the short forward contract. At the end of one
year, you find that the current market valuation of John's sailboat is $165,000. Because John
is obliged to sell his boat to you for only $150,000, you will have effectively made a profit of
$15,000. (You can buy the boat from John for $150,000 and immediately sell it for
$165,000.) John, unfortunately, has lost $15,000 in potential proceeds from the transaction.
Like all forward contracts, in this example, no money exchanged hands when the contract
was negotiated and the initial value of the contract was zero.

Derivatives - Forward Markets and Contracts: Settlement

Procedures
The differences between long and short positions in forward markets are as follows:

The long position holder is the buyer of the contract and the short position holder is
the seller of the contract.
The long position will take the delivery of the asset and pay the seller of the asset the
contract value, while the seller is obligated to deliver the asset versus the cash value
of the contract at the origination date of this transaction.
When it comes to default, both parties are at risk because typically no cash is
exchanged at the beginning of the transaction. However, some transactions do require

that one or both sides put up some form of collateral to protect them from the
defaulted party.
Procedures for Settling a Forward Contract at Expiration
A forward contact at expiration can be settled in one of two ways:
1. Physical Delivery - Refers to an option or futures contract that requires the actual
underlying asset to be delivered on the specified delivery date, rather than being
traded out with offsetting contracts. Most derivatives are not actually exercised, but
are traded out before their delivery dates. However, physical delivery still occurs with
some trades: it is most common with commodities, but can also occur with other
financial instruments. Settlement by physical delivery is carried out by clearing
brokers or their agents. Promptly after the last day of trading, the regulated exchange's
clearing organization will report a purchase and sale of the underlying asset at the
previous day's settlement price (also referred to as the "invoice price"). Traders who
hold a short position in a physically settled security futures contract to expiration are
required to make delivery of the underlying asset. Those who already own the assets
may tender them to the appropriate clearing organization. Traders who do not own
assets are obligated to purchase them at the current price.
Exchanges specify the conditions of delivery for the contracts they cover. Acceptable
locations for delivery (in the case of commodities or energies) and requirements as to
the quality, grade or nature of the underlying asset to be delivered are regulated by the
exchanges. For example, only certain Treasury bonds may be delivered under the
Chicago Board of Trade's Treasury bond future. Only certain growths of coffee may
be delivered under the Coffee, Sugar and Cocoa Exchange's coffee future. In many
commodity or energy markets, parties want to settle futures by delivery, but exchange
rules are too restrictive for their needs. For example, the New York Mercantile
Exchange requires that natural gas be delivered only at the Henry Hub in Louisiana, a
location that may not be convenient for all futures traders.
2. Cash Settlement - Refers to an option or futures contract that requires the
counterparties to the contract to net out the cash difference in the value of their
positions. The appropriate party receives the cash difference.In the case of cash
settlement, no actual assets are delivered at the expiration of a futures contract.
Instead, traders must settle any open positions by making or receiving a cash payment
based on the difference between the final settlement price and the previous day's
settlement price. Under normal circumstances, the final settlement price for a cashsettled contract will reflect the opening price for the underlying asset. Once this
payment is made, neither the buyer nor the seller of the futures contract has any
further obligations on the contract.
Example: Settling a Forward Contract
Let's return to our sailboat example from the first part of this section. Assume that at the end
of 12 months you are a bit ambivalent about sailing. In this case, you could settle your
forward contract with John in one of two ways:
1. Physical Delivery - John delivers that sailboat to you and you pay him $150,000, as
agreed.

2. Cash Settlement - John sends you a check for $15,000 (The difference between your
contract's purchase price of $150,000 and the sail boat's current market value of
$165,000).
The same options are available if the current market price is lower than the forward contract's
settlement price. If John's sailboat decreases in value to $135,000, you could simply pay John
$15,000 to settle the contract, or you could pay him $150,000 and take physical possession of
the boat. (You would still suffer a $15,000 loss when you sold the boat for the current price
of $135,000.)

Derivatives - Future Contracts

Future contracts are also agreements between two parties in which the buyer agrees to buy an
underlying asset from the other party (the seller). The delivery of the asset occurs at a later
time, but the price is determined at the time of purchase.

Terms and conditions are standardized.

Trading takes place on a formal exchange wherein the exchange provides a place to
engage in these transactions and sets a mechanism for the parties to trade these
contracts.
There is no default risk because the exchange acts as a counterparty, guaranteeing
delivery and payment by use of a clearing house.
The clearing house protects itself from default by requiring its counterparties to settle
gains and losses or mark to market their positions on a daily basis.
Futures are highly standardized, have deep liquidity in their markets and trade on an
exchange.
An investor can offset his or her future position by engaging in an opposite
transaction before the stated maturity of the contract.

Example: Future Contracts

Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per
bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for
his next crop, while McDonald's is trying to secure a buying price in order to determine how
much to charge for a Big Mac next year. The farmer and the corporation can enter into a
futures contract requiring the delivery of 5 million bushels of tomatoes to McDonald's in
December at a price of $3.50 per bushel. The contract locks in a price for both parties. It is
this contract - and not the grain per se - that can then be bought and sold in the futures
market.
In this scenario, the farmer is the holder of the short position (he has agreed to sell the
underlying asset - tomatoes) and McDonald's is the holder of the long position (it has agreed
to buy the asset). The price of the contract is 5 million bushels at $3.50 per bushel.
The profits and losses of a futures contract are calculated on a daily basis. In our example,
suppose the price on futures contracts for tomatoes increases to $4 per bushel the day after
the farmer and McDonald's enter into their futures contract of $3.50 per bushel. The farmer,
as the holder of the short position, has lost $0.50 per bushel because the selling price just

increased from the future price at which he is obliged to sell his tomatoes. McDonald's has
profited by $0.50 per bushel.
On the day the price change occurs, the farmer's account is debited $2.5 million ($0.50 per
bushel x 5 million bushels) and McDonald's is credited the same amount. Because the market
moves daily, futures positions are settled daily as well. Gains and losses from each day's
trading are deducted or credited to each party's account. At the expiration of a futures
contract, the spot and futures prices normally converge.
Most transactions in the futures market are settled in cash, and the actual physical commodity
is bought or sold in the cash market. For example, let's suppose that at the expiration date in
December there is a blight that decimates the tomato crop and the spot price rises to $5.50 a
bushel. McDonald's has a gain of $2 per bushel on its futures contract but it still has to buy
tomatoes. The company's $10 million gain ($2 per bushel x 5 million bushels) will be offset
against the higher cost of tomatoes on the spot market. Likewise, the farmer's loss of $10
million is offset against the higher price for which he can now sell his tomatoes.
Difference between Future and Forward Contracts:
Fundamentally, forward and futures contracts have the same function: both types of contracts allow
people to buy or sell a specific type of asset at a specific time at a given price.
However, it is in the specific details that these contracts differ. First of all, futures contracts are
exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand,
are private agreements between two parties and are not as rigid in their stated terms and
conditions. Because forward contracts are private agreements, there is always a chance that a party
may default on its side of the agreement. Futures contracts have clearing houses that guarantee the
transactions, which drastically lowers the probability of default to almost never.
Secondly, the specific details concerning settlement and delivery are quite distinct. For forward
contracts, settlement of the contract occurs at the end of the contract. Futures contracts are
marked-to-market daily, which means that daily changes are settled day by day until the end of the
contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward
contracts, on the other hand, only possess one settlement date.
Lastly, because futures contracts are quite frequently employed by speculators, who bet on the
direction in which an asset's price will move, they are usually closed out prior to maturity and
delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers
that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement
will usually take place.

Derivatives - Options: Calls and Puts

An option is common form of a derivative. It's a contract, or a provision of a contract, that
gives one party (the option holder) the right, but not the obligation to perform a specified
transaction with another party (the option issuer or option writer) according to specified
terms. Options can be embedded into many kinds of contracts. For example, a corporation
might issue a bond with an option that will allow the company to buy the bonds back in ten
years at a set price. Standalone options trade on exchanges or OTC. They are linked to a
variety of underlying assets. Most exchange-traded options have stocks as their underlying

asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies,
commodities, swaps, or baskets of assets).
There are two main types of options: calls and puts:

Call options provide the holder the right (but not the obligation) to purchase an
underlying asset at a specified price (the strike price), for a certain period of time. If
the stock fails to meet the strike price before the expiration date, the option expires
and becomes worthless. Investors buy calls when they think the share price of the
underlying security will rise or sell a call if they think it will fall. Selling an option is
also referred to as ''writing'' an option.
Put options give the holder the right to sell an underlying asset at a specified price (the
strike price). The seller (or writer) of the put option is obligated to buy the stock at the
strike price. Put options can be exercised at any time before the option expires.
Investors buy puts if they think the share price of the underlying stock will fall, or sell
one if they think it will rise. Put buyers - those who hold a "long" - put are either
speculative buyers looking for leverage or "insurance" buyers who want to protect
their long positions in a stock for the period of time covered by the option. Put sellers
hold a "short" expecting the market to move upward (or at least stay stable) A worstcase scenario for a put seller is a downward market turn. The maximum profit is
limited to the put premium received and is achieved when the price of the underlyer is
at or above the option's strike price at expiration. The maximum loss is unlimited for
an uncovered put writer.

To obtain these rights, the buyer must pay an option premium (price). This is the amount of
cash the buyer pays the seller to obtain the right that the option is granting them. The
premium is paid when the contract is initiated.

Derivatives - Options: Basic Characteristics

Both put and call options have three basic characteristics: exercise price, expiration date and
time to expiration.

The buyer has the right to buy or sell the asset.

To acquire the right of an option, the buyer of the option must pay a price to the seller.
This is called the option price or the premium.
The exercise price is also called the fixed price, strike price or just the strike and is
determined at the beginning of the transaction. It is the fixed price at which the holder
of the call or put can buy or sell the underlying asset.
Exercising is using this right the option grants you to buy or sell the underlying asset.
The seller may have a potential commitment to buy or sell the asset if the buyer
exercises his right on the option.
The expiration date is the final date that the option holder has to exercise her right to
buy or sell the underlying asset.
Time to expiration is the amount of time from the purchase of the option until the
expiration date. At expiration, the call holder will pay the exercise price and receive
the underlying securities (or an equivalent cash settlement) if the option expires in the
money. (We will discuss the degrees of moneyness later in this session.) The call
seller will deliver the securities at the exercise price and receive the cash value of
those securities or receive equivalent cash settlement in lieu of delivering the
securities.

Defaults on options work the same way as they do with forward contracts. Defaults on
over-the counter option transactions are based on counterparties, while exchangetraded options use a clearing house.

Example: Call Option

IBM is trading at 100 today. (June 1, 2005)
The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call =
$3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the
right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise
the option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of
$125 to the buyer.
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put =
$3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to
sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the
option on or before August 1, 2005, the seller will have to purchase IBM shares at a price of
$90.

Derivatives - Swaps
A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a
cash-settled contract between two parties to exchange (or "swap") cash flow streams. As long
as the present value of the streams is equal, swaps can entail almost any type of future cash
flow. They are most often used to change the character of an asset or liability without actually
having to liquidate that asset or liability. For example, an investor holding common stock can
exchange the returns from that investment for lower risk fixed income cash flows - without
having to liquidate his equity position.
The difference between a forward contract and a swap is that a swap involves a series of
payments in the future, whereas a forward has a single future payment.

Derivatives - Swap Markets and Contracts

Swaps are non-standardized contracts that are traded over the counter (OTC). However, to
facilitate trading, market participants have developed the ISDA Master Agreement, which
covers the 'non-economic' terms of a swap contract, such as representations and warranties,
events of default and termination events. Parties to the trade still need to negotiate the rate or
price, notional amount, maturity, collateral, etc.
Swaps are contracts that exchange assets, liabilities, currencies, securities, equity
participations and commodities. Some are simple, such as floating-for-fixed-rate loans or

Japanese yen for British pound sterling, while others are quite complex incorporating
multiple currencies, interest rates, commodities and options. Both types are flexible in terms
of specifications such as pricing or evaluation benchmarks, timing or contractual horizons,
settlement procedures, resets, and other variables.
Generally, swaps are used for risk management by institutions such as banks, brokers, dealers
and corporations. Some qualified individuals may also be suitable users of these basic
derivatives products. The following lists highlight common swaps transactions.

Commodities: agricultural, energy, metals

Currencies: amortization or amortizing, differential, forward rates, forward start
Equities: basket, differential or spread, indexed, individual security related
Interest Rates: amortization or amortizing, arrears, basis, fixed for floating, forward
start, inverse floater, zero coupon

Swap Characteristics

Most involve multiple payments, although one-payment contracts are possible

A series of forward contracts.
When initiated, neither party exchanges any cash; a swap has zero value at the
beginning.
One party tends to pay a fixed rate while the other pays on the movement of the
underlying asset. However, a swap can be structured so that both parties pay each
other on the movement of an underlying asset.
Parties make payments to each other on a settlement date. Parties may decide to
agree to just exchange the difference that is due to each other. This is called netting.
Final payment is made on the termination date.
Usually traded in the over-the-counter market. This means they are subject credit risk.

Terminating a Swap Contract

The easiest way to terminate the contract is to hold it to maturity. However, if one or both
parties in a swap contract wish to terminate, there are several methods:
1. Enter into a separate and offsetting swap. For example, an entity has a swap on its
books that pays a fixed rate and receives a floating rate based on LIBOR on January 1
and July 1. The entity can enter into a new swap that pays a floating rate based on
LIBOR and receives a fixed rate with payments on January 1 and July 1. With this
new transaction, your fixed rates may be different because of market rates, while the
LIBOR payments will wash out over the transaction's life. Credit risk will also
increase because you could have a new counterparty for the new swap.
2. The other way is to have a cash settlement based on market value. For example,
assume that a party holds a swap with a market value of $65,000. The contract could
be terminated if the other party pays the market value of the contract to the holder.
Said another way, if the party holding the swap has a negative value, it can terminate
the swap by paying its counterparty the market value of the swap. This terminates the
contract for both parties, but this is usually available only if it is stated before the
contract is entered into or agree upon by both parties at a later date.
3. Another way to terminate a swap is to sell the swap to another party. This usually
requires permission from the other party. This is not commonly used in the market
place.

4. The last way to terminate a contract is to use a swaption. A swaption works like an
option by giving the owner the right to enter into another swap at terms that are set in
advance. By executing the swaption, the party can offset its current swap as explained
in the first way to terminate a contract.

Derivatives - Currency Swaps

Like an interest rate swap, a currency swap is a contract to exchange cash flow streams from
some fixed income obligations (for example, swapping payments from a fixed-rate loan for
payments from a floating rate loan). In an interest rate swap, the cash flow streams are in the
same currency, while in currency swaps, the cash flows are in different monetary
denominations. Swap transactions are not usually disclosed on corporate balance sheets.
As we stated earlier, the cash flows from an interest rate swap occur on concurrent dates and
are netted against one another. With a currency swap, the cash flows are in different
currencies, so they can't net. Instead, full principal and interest payments are exchanged.
Currency swaps allow an institution to take leverage advantages it might enjoy in specific
countries. For example, a highly-regarded German corporation with an excellent credit rating
can likely issue euro-denominated bonds at an attractive rate. It can then swap those bonds
into, say, Japanese yen at better terms than it could by going directly into the Japanese market
where its name and credit rating may not be as advantageous.
At the origination of a swap agreement, the counterparties exchange notional principals in the
two currencies. During the life of the swap, each party pays interest (in the currency of the
principal received) to the other. At maturity, each makes a final exchange (at the same spot
rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each
party in the agreement has a comparative advantage over the other with respect to fixed or
floating rates for a certain currency. A typical structure of a fixed-for-floating currency swap
is as follows:

Calculating the Payments on a Currency Swap

Let's consider an example:
Firm A can borrow Canadian currency at a rate of 10% or can borrow U.S. currency at a
floating rate equal to six-month LIBOR. Firm B can borrow Canadian currency at a rate of
11% or U.S. currency at a rate of floating rate equal to six-month LIBOR. Although Firm A
can borrow Canadian currency at a cheaper rate than Firm B, it needs a floating-rate loan.
Additionally, Firm B needs a fixed-rate Canadian dollar loan. The loan is for US$20 million,
and will mature in two years.
Who has the comparative advantage?
To determine who has the comparative advantage, consider the fixed rates for each firm for
the currency required. In this case, Firm A's rate of 10% is less than Firm B's rate of 11%, so
Firm A has a comparative advantage in the fixed currency. That leaves Firm B to have a
comparative advantage with respect to the floating rate.

Derivatives - Interest Rate and Equity Swaps

Plain Vanilla Interest Rate Swap
In general, an interest rate swap is an agreement to exchange rate cash flows from interestbearing instruments at specified payment dates. Each party's payment obligation is computed
using a different interest rate. Although there are no truly standardized swaps, a plain vanilla
swap typically refers to a generic interest rate swap in which one party pays a fixed rate and
one party pays a floating rate (usually LIBOR).
For each party, the value of an interest rate swap lies in the net difference between the present
value of the cash flows one party expects to receive and the present value of the payments the
other party expects to make. At the origination of the contract, the value for both parties is
usually zero because no cash flows are exchanged at that point. Over the life of the contract,
it becomes a zero-sum game. As interest rates fluctuate, the value of the swap creates a profit
on one counterparty's books, which results in a corresponding loss on the other's books.
Example
A portfolio manager with a $1 million fixed-rate portfolio yielding 3.5% believes rates may
increase and wants to decrease his exposure. He can enter into an interest rate swap and trade
his fixed rate cash flows for floating rate cash flows that have less exposure when rates are
rising. He swaps his 3.5% fixed-rate interest stream for the three-month floating LIBOR rate
(which is currently at 3%). When this happens, he will receive a floating rate payment and
pay a fixed rate that is equivalent to the rate the portfolio is receiving, making his portfolio a
floating-rate portfolio instead of the fixed-rate return he was receiving. There is no exchange
of the principal amounts and the interest payments are netted against one another. For
example, if LIBOR is 3%, the manager receives 0.5%. The actual amounts calculated for
semiannual payments are shown below. The fixed rate (3.5% in this example) is referred to as
the swap rate.
A typical exam question concerning interest rate swaps follows:
Q. Two parties enter a three-year, plain-vanilla interest rate swap agreement to exchange the
LIBOR rate for a 10% fixed rate on $10 million. LIBOR is 11% now, 12% at the end of the

first year, and 9% at the end of the second year. If payments are in arrears, which of the
following characterizes the net cash flow to be received by the fixed-rate payer?
A. $100,000 at the end of year two.
B. $100,000 at the end of year three.
C. $200,000 at the end of year two.
D. $200,000 at the end of year three.
A. The correct answer is "C". What's important to remember is that the payments are in
arrears, so the end-of-year payments depend on the interest rate at the beginning of the year
(or prior year end). The payment at the end of year two is based on the 12% interest rate at
the end of year one. If the floating rate is higher than the fixed rate, the fixed rate payer
receives the interest rate differential times the principal amount ($10,000 x (0.12-0.10) =
$200,000).
Calculate the Payments on an Interest Rate Swap
Consider the following example:
Notional amount = $1 million, payments are made semiannually. The corporation will pay a
floating rate of three-month LIBOR, which is at 3% and will receive a fixed payment of
3.5%.
Answer:
Floating rate payment is $1 million(.03)(180/365) = $14,790
Fixed payment is $1 million(.035)(180/365) = $17,225
The corporation will receive a net payment of $2,435.
Equity Swaps
An equity swap is an agreement between counterparties to exchange a set of payments,
determined by a stock or index return, with another set of payments (usually an interestbearing (fixed or floating rate) instrument, but they can also be the return on another stock or
index). Equity swaps are used to substitute for a direct transaction in stock. The two cash
flows are usually referred to as "legs". As with interest rate swaps, the difference in the
payment streams is netted.
Equity swaps have many applications. For example, a portfolio manager with XYZ Fund can
swap the fund's returns for the returns of the S&P 500 (capital gains, dividends and income
distributions.) They most often occur when a manager of a fixed income portfolio wants the
portfolio to have exposure to the equity markets either as a hedge or a position. The portfolio
manager would enter into a swap in which he would receive the return of the S&P 500 and
pay the counterparty a fixed rate generated form his portfolio. The payment the manager
receives will be equal to the amount he is receiving in fixed-income payments, so the
manager's net exposure is solely to the S&P 500. These types of swaps are usually
inexpensive and require little in term of administration.
For individuals, equity swaps offer some tax advantages. The owner of $1 million worth of
XYZ stock watches his stock value increase by 25% over 12 months. He wants to take some
of the profit but does not want to actually sell his shares. In this case, he can enter into an
equity swap in which he pays a counterparty (perhaps his brokerage) the total return he

receives from his XYZ shares annually for the next three years. In return, he'll take the threemonth LIBOR rate. In this scenario, the owner of XYZ does not have to report any capital
gains on his stock and retains ownership of those stocks as well.

A total return equity swaps includes capital gains and dividends paid on the
underlying stock or stock index. No principal is exchanged and payments are set off
by a notional amount.

Calculate the Payments on an Equity Swap

Consider the following example:
Notional principal amount = $1 million
Payments made semi-annual
Fund manager will pay the broker/dealer the return of the S&P 500 and will receive an
interest payment of 5% every six months
Index is at 10,500 at the start of the swap
Results:
Six months from now the index is at 11,000.

The fixed payment the fund will receive is:

$1 million(0.05) 182/365 = $24,931.51
The index payment the fund must make is:
(11,000/10,500 -1) $1 million = $47,619.04

The net payment the fund must make at the end of the first six months is $22,687.50
(47,619.04 - 24,931.51).