Demystifying Derivatives: An Introduction to Futures, Options, Forwards and Swaps

Imagine you’re at a farmers market and you see a sign for apples that are going to be harvested in three months. The farmer, Anna, is selling the option to buy a basket of apples at today’s price, $5, when they are harvested. You love apples and think that’s a great deal because the price of apples might go up. So, you decide to buy an option from Anna.

This option you bought is similar to a call option in finance. It gives you the right to buy the apples at $5 (the strike price) in three months, regardless of the market price at that time. You pay Anna $1 for this option today. This $1 is like the premium in options trading.

Now, let's say harvest time comes and the market price of a basket of apples has risen to $10. Because you have the call option, you can still buy the basket for $5. You exercise your option, pay Anna $5, and enjoy your apples, saving $5. However, if the market price had fallen to $3, you could choose not to exercise your option, forfeiting the $1 premium but avoiding a bad deal.

Alternatively, imagine if you were growing tomatoes and worried that the price might drop by the time you harvest them. You could sell a put option to guarantee a sale price. If someone buys this option, they pay you a premium now for the right to sell tomatoes to you at a set price later. This protects them if prices drop, and you earn extra from the premium if prices stay high or go higher.

In both scenarios, options help manage risk against price changes. Call options protect against price rises, and put options protect against price falls. And like in our story, you don’t have to exercise the option if it doesn’t benefit you, but the premium paid is always non-refundable.

Alright, let's explore futures contracts with a story:

Imagine you're a baker named Bob who specializes in making blueberry pies. Blueberries are essential to your business, but their prices can fluctuate a lot, which makes your business planning tough.

One day, while buying supplies at the market, you meet Lisa, a blueberry farmer. You two start talking about the difficulties of predicting costs and revenues due to fluctuating blueberry prices. To solve this problem, you both agree to a futures contract.

Here’s how it works: Today, you and Lisa agree that in six months, you will buy 100 pounds of blueberries from her at $3 per pound, which is the price today. This agreement is your futures contract.

For you, the baker, this contract means you can plan your expenses precisely because you know exactly how much the blueberries will cost you in the future, no matter what happens in the market. Whether the price of blueberries goes up due to a bad harvest or falls due to an oversupply, you still pay $3 per pound. This helps you manage your budget and pricing for the pies.

For Lisa, the farmer, this contract guarantees that she will have a buyer for her blueberries at a known price, even if the market price drops. This reduces her risk of losing income due to a price drop.

If the price of blueberries goes up to $5 per pound in six months, you benefit because you save $2 per pound based on your contract. But if the price falls to $1, Lisa benefits because she’s still getting $3 per pound from you, much more than the market rate.

Neither of you has to worry about changing blueberry prices. You both have managed your risk by locking in a price early with a futures contract. This is exactly how futures work in finance: they help businesses manage risks by allowing them to fix prices for buying or selling goods in advance.

Sure, let’s use a story to explain forwards:

Imagine that your friend Mia owns a coffee shop that serves delicious pastries and fresh coffee. The coffee shop is very popular, and a key ingredient for her success is high-quality coffee beans. However, the price of coffee beans can be quite volatile, fluctuating due to various market conditions.

To secure a steady supply of coffee beans at a predictable price, Mia meets with Joe, a local coffee bean farmer. They decide to enter into a forward contract. Here’s how it works:

Mia and Joe agree that in six months, Mia will buy 1,000 pounds of coffee beans from Joe at $4 per pound, the price today. This agreement is not made through an exchange but directly between Mia and Joe, tailored to their specific needs.

For Mia, this contract is beneficial because it locks in the cost of her key ingredient. She can budget better and plan her menu pricing without worrying about fluctuating coffee bean prices. Whether the market price rises to $5 per pound or drops to $3, Mia is assured she will get her coffee beans at $4 per pound.

For Joe, the farmer, this agreement secures a buyer for his coffee beans in advance, guaranteeing him revenue regardless of future price drops. This helps him plan his farming operations and manage his financials with more certainty.

If the market price of coffee beans increases significantly at the time of delivery, Mia benefits because she secured a lower price through the forward contract. Conversely, if the market price decreases, Joe benefits because he still sells his coffee beans at the agreed-upon higher price.

This scenario shows how forward contracts help both buyers and sellers manage their financial risks by fixing prices in advance, allowing them to plan their operations and finances more effectively.

Imagine two friends, Emily and Tom, who both own businesses that require taking loans for operations. Emily runs a bakery in the U.S., and she has a loan with a variable interest rate—meaning the interest she pays can increase or decrease depending on market conditions. Tom owns a café in Europe and has a loan with a fixed interest rate—meaning his interest payments remain the same throughout the loan term.

During a catch-up over coffee, Emily and Tom discuss the challenges of managing their business finances, especially concerning their loans. Emily expresses concern about her variable rate possibly going up, which would increase her payments. Tom, on the other hand, wishes he had a variable rate because current trends suggest rates might go down, which could have reduced his payments.

Seeing an opportunity to help each other, they agree to enter into a swap agreement. Here's what they decide:

• Emily will swap her variable interest payments with Tom’s fixed interest payments. This means Emily will take over Tom's fixed interest rate, and Tom will take over Emily's variable rate.

The swap works like this:

• If interest rates go up, Tom benefits because he pays a variable rate that is now lower than the fixed rate he used to pay, while Emily protects her cash flow from rising rates because she pays a fixed rate.
• If interest rates go down, Emily might feel like she’s losing out because she's locked into a higher fixed rate, but she gains peace of mind knowing exactly what her payments will be. Meanwhile, Tom takes advantage of the lower variable rates.

This kind of financial arrangement is common in business and finance, where two parties exchange cash flows of one kind for another to take advantage of expected changes in interest rates or currency exchange rates, among other things. Swaps help businesses manage risks associated with fluctuations in rates or to reduce their costs.