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

A derivative asset is a contract potentially leading to a future transaction. Its value depends on the value of other more fundamental variables, such as the price of a share or the value of an index.

Demystifying Derivatives: An Introduction to Futures, Options, Forwards and Swaps
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A derivative asset is a contract potentially leading to a future transaction. Its value depends on the value of other more fundamental variables, such as the price of a share or the value of an index.

Options, Futures, and Other Derivatives, John Hull, Pearson

In this article, we present a simple and brief overview of derivative products.

We'll look at four derivative assets:

  • Options
  • Futures
  • Forwards
  • Swaps

TLDR :

The Motley Fool

Options :

An option is a contract between a buyer and a seller that gives the holder (the buyer) the right, but not the obligation, to exercise it for a pre-determined price.

A concrete example about Options

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.


Futures :

A future contract is a standardized agreement to buy or sell an asset at a set price on a future date.
  • Traded on exchanges, these contracts are used to hedge against price changes or to speculate on price movements of underlying assets.
  • Futures are marked to market daily, requiring buyers and sellers to maintain margin accounts to cover potential losses.
  • They can be settled either through physical delivery of the asset or by cash.

A concrete example about Futures


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.


Forwards :

A forward contract is a customized agreement between two parties to buy or sell an asset at a specified price on a future date.
  • Unlike futures, forwards are traded over-the-counter and not on an exchange, allowing for greater flexibility and customization in terms of the contract terms. They are commonly used for hedging risk and are settled at the end of the contract, either by physical delivery or cash settlement.

A concrete example about Forwards


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.


Swaps :

A swap is a financial derivative where two parties exchange cash flows or liabilities from two different financial instruments.
  • Most commonly, the exchanges involve cash flows based on a notional principal amount that both parties agree to.
  • Swaps can be used to manage interest rate risk, currency exchange rate risk, and credit risk.
  • They typically do not involve exchanges of principal and are settled in cash.

A concrete example about Swaps

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.


Books recommendations :

Options, Futures, and Other Derivatives, John Hull, Pearson

For courses in business, economics, and financial engineering and mathematics.
The definitive guide to the derivatives market, updated with contemporary examples and discussions
Known as 'the bible' to business and economics professionals and a consistent best-seller, Options, Futures, and Other Derivatives gives readers a modern look at the derivatives market. By incorporating the industry's hottest topics, such as the securitisation and credit crisis, author John C. Hull helps bridge the gap between theory and practice. The 11th Edition covers all the latest regulations and trends, including the Black-Scholes-Merton formulas, overnight indexed swaps, and the valuation of commodity derivatives.

Buy on Amazon

Option Volatility and Pricing: Advanced Trading Strategies and Techniques, Sheldon Natenberg, McGraw Hill

The bestselling Option Volatility & Pricing has made Sheldon Natenberg a widely recognized authority in the option industry. At firms around the world, the text is often the first book that new professional traders are given to learn the trading strategies and risk management techniques required for success in option markets.

Now, in this revised, updated, and expanded second edition, this thirty-year trading professional presents the most comprehensive guide to advanced trading strategies and techniques now in print. Covering a wide range of topics as diverse and exciting as the market itself, this text enables both new and experienced traders to delve in detail into the many aspects of option markets, including:

  • The foundations of option theory
  • Dynamic hedging
  • Volatility and directional trading strategies
  • Risk analysis
  • Position management
  • Stock index futures and options
  • Volatility contractsClear, concise, and comprehensive, the second edition of Option Volatility & Pricing is sure to be an important addition to every option trader's library--as invaluable as Natenberg's acclaimed seminars at the world's largest derivatives exchanges and trading firms.You'll learn how professional option traders approach the market, including the trading strategies and risk management techniques necessary for success. You'll gain a fuller understanding of how theoretical pricing models work. And, best of all, you'll learn how to apply the principles of option evaluation to create strategies that, given a trader's assessment of market conditions and trends, have the greatest chance of success.Option trading is both a science and an art. This book shows how to apply both to maximum effect.

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Buy on Amazon

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