TYPES OF DERIVATIVES, part 2
In futures markets, the contracts have standardized terms and trade in a market that provides sufficient liquidity to permit the parties to enter the market and offset transactions previously created. The use of contracts with standardized terms results in relatively widespread acceptance of these terms as homogeneous agreed-upon standards for trading these contracts. For example, a U.S. Treasury bond futures contract covering $100,000 face value of Treasury bonds, with an expiration date in March, June, September, or December, is a standard contract. In contrast, if a party wanted a contract covering $120,000 of Treasury bonds, he would not find any such instrument in the futures markets and would have to create a nonstandard instrument in the forward market. The acceptance of standardized terms makes parties more willing to trade futures contracts. Consequently, futures markets offer the parties liquidity, which gives them a means of buying and selling the contracts. Because of this liquidity, a party can enter into a contract and later, before the contract expires, enter into the opposite transaction and offset the position, much the same way one might buy or sell a stock or bond and then reverse the transaction later. This reversal of a futures position completely eliminates any further financial consequences of the original transaction.
A swap is a variation of a forward contract that is essentially equivalent to a series of forward contracts. Specifically, a swap is an agreement between two parties to exchange a series of future cash flows. Typically at least one of the two series of cash flows is determined by a later outcome. In other words, one party agrees to pay the other a series of cash flows whose value will be determined by the unknown future course of some underlying factor, such as an interest rate, exchange rate, stock price, or commodity price. The other party promises to make a series of payments that could also be determined by a second unknown factor or, alternatively, could be preset. We commonly refer to swap payments as being “fixed” or “floating” (sometimes “variable”).
We noted that a forward contract is an agreement to buy or sell an underlying asset at a future date at a price agreed on today. A swap in which one party makes a single fixed payment and the other makes a single floating payment amounts to a forward contract. One party agrees to make known payments to the other and receive something unknown in return. This type of contract is like an agreement to buy at a future date, paying a fixed amount and receiving something of unknown future value. That the swap is a series of such payments distinguishes it from a forward contract, which is only a single payment. Swaps, like forward contracts, are private transactions and thus not subject to direct regulation. Swaps are arguably the most successful of all derivative transactions. Probably the most common use of a swap is a situation in which a corporation, currently borrowing at a floating rate, enters into a swap that commits it to making a series of interest payments to the swap counterparty at a fixed rate, while receiving payments from the swap counterparty at a rate related to the floating rate at which it is making its loan payments. The floating components cancel, resulting in the effective conversion of the original floating-rate loan to a fixed-rate loan.
Forward commitments (whether forwards, futures, or swaps) are firm and binding agreements to engage in a transaction at a future date. They obligate each party to complete the transaction, or alternatively, to offset the transaction by engaging in another transaction that settles each party’s financial obligation to the other. Contingent claims, on the other hand, allow one party the flexibility to not engage in the future transaction, depending on market conditions.