Many investors use derivative securities as a way to hedge their investment portfolios against certain risk. A derivative security derives its value from another underlying financial security. Derivative securities come in several types, including forward, future, swap and option contracts. Derivatives are considered sophisticated financial securities, so it is important for investors to understand how they work and the benefits and risks associated with them.
A forward contract is an agreement in which a seller promises to deliver a predetermined quantity of an asset at a certain date and price to a buyer. The price of a forward contract is determined at the initial trade date although the asset is delivered in the future. Most forward contracts are private agreements and are not traded on exchanges. For example, a farmer may enter into a forward contract to lock in the price of wheat if he believes that price will rise in the future. Unlike future contracts, forward contracts are typically made by hedgers who desire to reduce price volatility, so the delivery of goods is almost always made. The risk of default is greater for forward contracts than future contracts.
Similar to a forward contract, a futures contract represents an agreement for a seller to deliver goods at a specified time for a predetermined price. Unlike a forward contract, future contracts are standardized, traded on exchanges and created by a clearinghouse that acts a middleman between the seller and buyer. The benefit of the clearinghouse is that the risk of default is eliminated. The parties of futures contracts are required to post margin, which the brokerage firm uses as collateral. The underlying assets vary and may include corn, wheat, pork bellies, gold, silver, copper and interest rates. Investors are almost always speculators who close the agreement before the maturity date, so goods are likely never delivered.
A swap is a type of derivative security in which investors swap one set of cash flow for another set of cash flow. A currency swap is a common type of swap in which parties enter a contract to exchange streams of cash flow denominated in two currencies. For example, a company based in the United States may need to acquire Japanese yen and a Japanese company may need to acquire U.S. dollars. The two parties can enter into a contract to exchange currency at a predetermined interest rate for a certain amount and on a specific date. Another common type of swap is an interest rate swap, which is an agreement where one stream of future interest rate payments is exchanged for another party’s fixed cash flows.
Two types of option contracts exist – call options and put options. Investors purchase a call option to buy a stock at a specified price and date, and a put option allows investors to sell a stock at specified price and date. Investors of call options realize a profit if the price of the underlying asset rises from the time the contract is initiated. Put option investors profit when the price declines. Option investors are not obligated to buy the underlying asset at the contract’s expiration date. The value of an option is determined by its exercise date, time remaining until expiration, the volatility and current market price of the underlying asset and the current interest rate.
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