Page 15 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 2. Futures: A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts. Unlike
forward contracts, the counterparty to a futures contract is the clearing corporation on the
appropriate exchange. Futures often are settled in cash or cash equivalents, rather than
requiring physical delivery of the underlying asset. Parties to a Futures contract may buy
or write options on futures.
3. Options: An option represents the right (but not the obligation) to buy or sell a security or
other asset during a given time for a specified price (the “strike price”). Options are of two
types - calls and puts. Calls give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given future date. Puts give
the buyer the right, but not the obligation to sell a given quantity of the underlying asset
at a given price on or before a given date.

4. Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. Swaps generally are traded OTC through swap dealers, which generally consist
of large financial institution, or other large brokerage houses. There is a recent trend for
swap dealers to mark to market the swap to reduce the risk of counterparty default. The
two commonly used swaps are:
(a) Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
(b) Currency swaps: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the
opposite direction. Swaps may involve cross-currency payments (U.S. Dollars vs.
Mexican Pesos) and cross market payments, e.g., U.S. short-term rates vs. U.K. short-
term rates.

1.4.2 Other Types of Financial Derivatives

1. Warrants: Options generally have lives of up to one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

2. LEAPS: The acronym LEAPS means Long-term Equity Anticipation Securities. These are
options having a maturity of up to three years.
3. Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form of
basket options.

Self Assessment

Fill in the blanks:

10. A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a ……………... .
11. An …………….. represents the right (but not the obligation) to buy or sell a security or
other asset during a given time for a specified price.
12. …………… are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula.
13. Basket options are options on …………… of underlying assets.

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