Futures, Forwards, and Swaps

Derivatives can be divided into forward commitments and contingent claims. A forward commitment. is a contractual agreement between two parties, which involves an obligation to buy or sell an underlying asset at the expiration date of the contract and at a price that is specified at the start of the agreement. Examples are futures and forwards, which differ in that the former are traded on an exchange and the latter over the counter. Swaps also belong to the category of forward commitments and, like forwards, are traded over the counter. By contrast, a contingent claim grants the buyer the right to buy (call option) or to sell (put option) the underlying asset at the agreed strike price either during or at the end of the option life. The option seller, on the other hand, has the obligation to sell (call option) or buy (put option) the underlying asset at the strike price. The chapter begins with the use of derivatives, which includes risk hedging, risk-taking (speculation and trading), and the exploitation of price differences (arbitrage). After differentiating between futures and forwards, the calculation of profit/loss, price, and value is explained. This is followed by a discussion of how forwards and futures can be applied to hedge risky positions. The chapter ends with an examination of interest rate swaps.