Derivative contracts are broadly categorized into (a) forward commitments, and (b) contingent claims.
Forward commitments
Forward commitments are contracts entered into today that obligates by parties will exchange the underlying at the forward price. Forward commitments include forward contracts, futures contracts, and swaps.
Forward contract
A forward contract is a customized forward commitment which is traded over the counter. At least one party may face default risk in a forward contract equal to the net position of the contract. If there is no default risk, it offers a perfect hedge.
At the time of inception of a forward contract, no exchange takes place and the net position is zero. The payoff to the long position (buyer) equals the spot price of the underlying minus the forward price. The payoff to the short position is exactly the opposite of that to the long position i.e. – (S – F) = F – S.
Forward contracts need not be settled by physical delivery but can also be settled by the loser paying the winner an equivalent amount of cash in what is referred to as cash-settled/non-deliverable forwards.
Futures contracts
Futures are a standardized exchange-traded version of the forward contracts. Futures exchanges are highly-regulated entities that offer clearing facility, default-protection, and increased liquidity.
Marking to market, initial margin and maintenance margin
Futures contracts are marked to market daily i.e. gains and losses are determined, and cash flows occur daily. This is possible because exchanges require margin accounts, an initial margin, a performance bond deposit from both parties. They also set a maintenance margin, which is lower than the initial margin, the minimum balance below which a party’s account balance can fall.
Margin call
If as a result of marking to market, a party’s balance falls below the maintenance margin, he receives a margin call, requiring him to deposit an amount enough to bring his balance to the initial margin. The purpose of this rule is to allow a cushion.
Role of the clearinghouse
If prices move so suddenly that a party’s account balance turns negative and he cannot pay the funds, the clearinghouse must pay the winning party on its own. The risk of very sharp movement in prices has necessitated creation of price limit provision in many contracts, the maximum amount by which a price can change up or down. A contract reaches a locked limit if the market participants want to trade at a price above (below) the upper (lower) band, the limit up (down) and the settlement doesn’t occur.
Open interest
Since many futures contracts are cash-settled, offsetting is common. The total number of currently open contracts is called open interest and these change as people open new positions and offset old ones.
Forward contracts vs futures contracts
Futures contracts payoff differs from forwards in that forward’s cash flows occur at expiration while a future’s cash flows occur daily (due to marking to market). At the expiration, the futures price automatically converges to the spot price. But since futures/forwards maturity is short and payoffs can be both positive/negative and small, the ultimate impact of the difference may be small. Futures contracts have lower credit risk because not all cash flows are received at expiration.
Forward contracts have advantages when privacy is important (i.e. when the order size is high), flexibility is needed both from regulation and structure of the contract, for example, hedging might be easier with forwards, etc. But futures offer credit guarantee. Hence, there is no clear winner, and the choice of contract depends on an investor’s goals.
Swaps
A swap is a contract in which two parties agree to exchange a series of cash flows in which at least one is variable and dependent upon some underlying. Even though a swap is a fairly young instrument, it is the most commonly used derivative.
Swaps are similar to a forward in that they are traded over the counter, have credit risk and only one party can default (because the payoff is passed on net position), they are also like futures in that swaps can be replicated by a series of forwards.
Fixed-for-floating swap
The most popular swap is a fixed-for-floating swap, also called plain-vanilla swap. It is useful, for example, for companies with a floating-rate loan linked with LIBOR which want to convert it to a fixed-rate loan. The company would enter into a swap, choosing to pay a fixed cash flows and receive variable cash flows indexed to LIBOR. No actual exchange of principal takes place in a swap at inception instead it is based on notional principal. The notional principal must match the loan being hedged, for example, it must decrease in case of an amortizing loan.
Swaps have zero value at inception and as the price of the underlying changes, net value to one party becomes position (and the other negative). They are subject to significant credit risk (even though lower than the associated loan).
Other types of swaps include basis swap, overnight-index swap, etc. A basis swap is a floating-for-floating swap, for example, where one party may pay based on Libor and other at US T-bill rate. The difference in interest rate is called TED spread. Overnight-indexed swaps are tied to the Fed funds rate.
Contingent claims
A contingent claim is derivative which entitles one party to a right but not an obligation to accept a payoff that is contingent/dependent on an underlying asset. Contingent claims are also called options.
Options
An option is a contract in which the buyer pays a premium to a seller in consideration of a right but not an obligation to receive a payoff contingent on an underlying.
The basic features of an option are that they limit losses in one direction and transform payoffs very differently. There are standardized exchange-traded options, customized OTC-traded options, physically-settled options, cash-settled options, etc. Exchange-traded options have protection against default.
Call option vs put option
A call option entitles the holder/buyer to buy the underlying (obtain long position) while a put option entitles him to sell (short position). An American-style call/put option can be exercised at any time before expiration while a European-style call/put option can be exercised only at expiration.
Options specify an exercise price (also called the strike price) which is the price at which the buyer can execute transactions. Since the buyer pays the option premium, which is essentially the present value of expected payoff, the seller does not face any credit risk, but the buyer does.
Contingent claims have payoffs that are linked non-linearly with the movement in the price of the underlying. Further, investors with a bullish view buy call options an those with a bearish view buy put options.
Credit derivatives
While credit insurance traditionally received little traction, credit derivatives have become popular due to their lower regulatory restrictions.
Popular credit derivatives include:
Total return swap
A swap in which an owner of bond or loan, Party A, pays all bond/loan cash flows he receives to a counterparty, Party B, in return for guaranteed cash flows at a fixed or floating rate of return. This arrangement gives Part A credit protection because the default risk of the bond cash flows is now transferred to Party B.
Credit spread option
A call option on a yield spread (excess of a bond’s yield over some benchmark yield) which entitles the option holder to receive compensation when the actual spread exceeds the strike spread.
Credit-linked note
A security issued by bondholder (credit protection buyer) whose payoff is linked with a bond such that when the bond defaults, the payoff on the note to the noteholder (credit protection seller) decreases.
Credit default swap (CDS)
A swap in which the credit protection buyer pays regular payments and the credit protection seller pays an amount if a credit event such as bankruptcy, rating downgrade, etc. occurs. It is a derivative which most closely resembles insurance. The amount paid to the buyer of CDS is either the defaulted amount, fixed amount or an amount determined through auction (most common). The success of a CDS seller lies in not getting overexposed to correlated risks.
Asset-backed securities
The distinguishing features of asset-backed securities are that they may have different classes of interest each with different preference/ranking of claim on the securitized assets and associated cash flows.
Collateralized mortgage obligations (CMOs) are securities backed by pools of mortgages such that each tranche is subject to a different level of prepayment risk. Many also include a credit default swap to remove credit risk and focus on prepayment risk.
Collateralized debt obligations (CDOs), further classified into collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs), have tranches with different exposure to credit risk.
Asset-backed securities, particularly tranches with higher exposure, are effectively like options.
Hybrids
Hybrid instruments are a combination of different instruments such as a bond and an option, for example in a callable bond, a stock and option, an option and a futures contract, a swap, and an option, etc.
Derivatives underlyings
An underlying is a variable to which the payoff of a derivative is linked. Common underlying (assets) are as follows:
- Equities: Equities are used as underlying either as individual stocks or indexes. Options are common on individual stocks while indexes have forwards, futures, options, and most importantly swaps called equity swaps, which are used in asset allocation. Further, companies issue stock options as compensation to its employees, and warrants to the public which entitles them to buy shares directly from companies.
- Fixed-income securities and interest rate: All types of derivative contracts are common on bonds, but since a single issuer has more than one bond issue outstanding, they allow the delivery of multiple issues on a single contract. In many cases, derivative contracts exist not on a bond, but the interest rate.
- Currencies: All types of derivatives are common on currencies, which represent an extremely large derivatives market. Currency derivatives are often linked to another underlying, such as interest rate which adds complexity to the payoff and valuation.
- Commodities: Commodity prices are subject to a range of risks. Primary commodity derivatives are futures, but others are also used. Commodity futures were one of the first futures ever sold.
- Credit: Credit act as underlying in credit default swaps, credit-linked notes, CDOs, etc.
- Others: weather measured in rainfall, snowfall, temperate; electricity, etc.