Assignment 3 Chapter 1

Different Types of Forwards, Futures and Swap Contracts

Hatem Hassan Zakaria

A. Forward contract
1. Definition
forward contract or simply a forward is a non-standardized contract between two
parties to buy or to sell an asset at a specified future time at a price agreed upon today,
making it a type of derivative instrument. This is in contrast to a spot contract, which is
an agreement to buy or sell an asset today.
The party agreeing to buy the underlying asset in the future assumes a long position, and
the party agreeing to sell the asset in the future assumes a short position. The price agreed
upon is called the delivery price, which is equal to the forward price at the time the
contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of the
instrument changes. This is one of the many forms of buy/sell orders where the time and
date of trade is not the same as the value date where the securities themselves are
exchanged.
The forward price of such a contract is commonly contrasted with the spot price, which is
the price at which the asset changes hands on the spot date. The difference between the
spot and the forward price is the forward premium or forward discount, generally
considered in the form of a profit, or loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a
quality of the underlying instrument which is time-sensitive.
A closely related contract is a futures contract; they differ in certain respects. Forward
contracts are very similar to futures contracts, except they are not exchange-traded, or
defined on standardized assets.
Forwards also typically have no interim partial settlements or "true-ups" in margin
requirements like futures such that the parties do not exchange additional property
securing the party at gain and the entire unrealized gain or loss builds up while the
contract is open. However, being traded over the counter (OTC), forward contracts
specification can be customized and may include mark-to-market and daily margin calls.
Hence, a forward contract arrangement might call for the loss party to pledge collateral or
additional collateral to better secure the party at gain.
In other words, the terms of the forward contract will determine the collateral calls based
upon certain "trigger" events relevant to a particular counterparty such as among other
things, credit ratings, value of assets under management or redemptions over a specific
time frame, e.g., quarterly, annually, etc.

A forward is an agreement between two counterparties - a buyer and seller. The buyer
agrees to buy an underlying asset from the other party (the seller). The delivery of the
asset occurs at a later time, but the price is determined at the time of purchase. Key
features of forward contracts are:

Highly customized - Counterparties can determine and define the terms and
features to fit their specific needs, including when delivery will take place and the
exact identity of the underlying asset.
All parties are exposed to counterparty default risk - This is the risk that the other
party may not make the required delivery or payment.
Transactions take place in large, private and largely unregulated markets
consisting of banks, investment banks, government and corporations.
Underlying assets can be a stocks, bonds, foreign currencies, commodities or
some combination thereof. The underlying asset could even be interest rates.
They tend to be held to maturity and have little or no market liquidity.
Any commitment between two parties to trade an asset in the future is a forward
contract.

2. different types of forward contract

A.

Time option forward contract

This is a forward contract that allows access to the funds between two predetermined dates eg. 01/04/00 - 31/08/00. This is of particular benefit when,
for example a car delivery is not precisely known, and therefore funds may be
needed earlier. It is important to remember that the last date is not flexible and
physical delivery of the currency can take place before but no later than that
date.

B.

Drawdown forward contract

This is similar to a time option forward contract, however, if a portion of the
funds are required during the life of the contract then they may be drawn
down against the said contract at the original buy rate, thereby reducing the
final balance. This would particularly suit either a boat or house purchase
where large sums maybe needed to settle stage payments. Its structure also
lends itself to corporate clients with large capital payments as the minimum is
circa. 75,000. Draw down payments will incur a small fee.

C.

Fixed term forward contract

A Fixed-Term Forward Contract gives you the ability to fix a currency rate
with a view to take physical delivery of the said currency in the future. The
rate is guaranteed irrespective of market fluctuations for the duration of the
Contract.

A deposit is required on each Forward Contract and must be received within two (2)
working days of the contract date. The balance of the contract must be settled no later
than the maturity date. We recommend that our clients settle the outstanding balance on
their contracts five (5) working days prior to the contract matures. Should the delivery of
the currency not be required upon maturity, the said currency can usually be held on
account at no additional charge or penalty.

B. Futures contract
A. Definition
a futures contract (more colloquially, futures) is a standardized contract between two
parties to buy or sell a specified asset of standardized quantity and quality for a price
agreed upon today (the futures price) with delivery and payment occurring at a specified
future date, the delivery date, making it a type of derivative instrument. The contracts are
negotiated at a futures exchange, which acts as an intermediary between the two parties.
The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is
said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the
contract, is said to be "short".
While the futures contract specifies a trade taking place in the future, the purpose of the
futures exchange institution is to act as intermediary and minimize the risk of default by
either party. Thus the exchange requires both parties to put up an initial amount of cash
(performance bond), the margin.
Additionally, since the futures price will generally change daily, the difference in the
prior agreed-upon price and the daily futures price is settled daily also (variation margin).
The exchange will draw money out of one party's margin account and put it into the
other's so that each party has the appropriate daily loss or profit. If the margin account
goes below a certain value, then a margin call is made and the account owner must
replenish the margin account.
This process is known as marking to market. Thus on the delivery date, the amount
exchanged is not the specified price on the contract but the spot value (i.e. the original
value agreed upon, since any gain or loss has already been previously settled by marking
to market).

A closely related contract is a forward contract. A forward is like a futures in that it

specifies the exchange of goods for a specified price at a specified future date. However,
a forward is not traded on an exchange and thus does not have the interim partial
payments due to marking to market. Nor is the contract standardized, as on the exchange.
Unlike an option, both parties of a futures contract must fulfill the contract on the
delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cashsettled futures contract, then cash is transferred from the futures trader who sustained a
loss to the one who made a profit. To exit the commitment prior to the settlement date,
the holder of a futures position can close out its contract obligations by taking the
opposite position on another futures contract on the same asset and settlement date. The
difference in futures prices is then a profit or loss.
Future contracts are also agreements between two parties in which the buyer agrees to
buy an underlying asset from the other party (the seller). The delivery of the asset occurs
at a later time, but the price is determined at the time of purchase.

Terms and conditions are standardized.

Trading takes place on a formal exchange wherein the exchange provides a place
to engage in these transactions and sets a mechanism for the parties to trade these
contracts.
There is no default risk because the exchange acts as a counterparty, guaranteeing
delivery and payment by use of a clearing house.
The clearing house protects itself from default by requiring its counterparties to
settle gains and losses or mark to market their positions on a daily basis.
Futures are highly standardized, have deep liquidity in their markets and trade on
an exchange.
An investor can offset his or her future position by engaging in an opposite
transaction before the stated maturity of the contract.

Example: Future Contracts

Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25
per bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling
price for his next crop, while McDonald's is trying to secure a buying price in order to
determine how much to charge for a Big Mac next year. The farmer and the corporation
can enter into a futures contract requiring the delivery of 5 million bushels of tomatoes to
McDonald's in December at a price of $3.50 per bushel. The contract locks in a price for
both parties. It is this contract - and not the grain per se - that can then be bought and sold
in the futures market.

In this scenario, the farmer is the holder of the short position (he has agreed to sell the
underlying asset - tomatoes) and McDonald's is the holder of the long position (it has
agreed to buy the asset). The price of the contract is 5 million bushels at $3.50 per bushel.

B. Types of Futures contracts

Depending on the type of underlying asset, there are different types of futures contract
available for trading. They are

Individual stock futures.

Stock index futures.
Commodity futures.
Currency futures.
Interest rate futures.
A. INDIVIDUAL STOCK FUTURES

Individual stock futures are the simplest of all derivative instruments.

B. STOCK INDEX FUTURES.
Understanding stock index futures is quite simple if you have understood individual stock
futures. Here the underlying asset is the stock index. For example the S&P CNX Nifty
popularly called the nifty futures. Stock index futures are more useful when speculating
on the general direction of the market rather than the direction of a particular stock. It can
also be used to hedge and protect a portfolio of shares. So here, the price movement of
an index is tracked and speculated. One more point to note here is that, although stock
index is traded as an asset, it cannot be delivered to a buyer. Hence, it is always cash
settled.
Both individual stock futures and index futures are traded in the NSE.

C. COMMODITY FUTURES
Its the same as individual stock futures. The underlying asset however would be a
commodity like gold or silver. In India, Commodity futures are mainly traded in two
exchanges 1. MCX (Multi commodity exchange) and NCDEX (National commodities
and derivatives exchange). Unlike stock market futures where a lot of parameters are
measured, the commodity market is predominantly driven by demand and supply.
The term commodity is a very broad term and it includes

Bullion gold and silver

Metals Aluminum , copper, lead, iron, steel, nickel, tin, zinc
Energy-crude oil, gasoline, heating oil, electricity, natural gas
Weather- carbon
Oil and oil seeds crude palm oil, kapsica khali,refined Soya oil, Soya bean
Cereals- barley, wheat, maize
Fiber- cotton, kapas
Species-cardamom, coriander, termuric etc
Pluses chana
Others- like potatoes, sugar, almonds, gaur
D. CURRENCY FUTURES.

The MCX-SX exchange trades the following currency futures:

Euro-Indian Rupee (EURINR),

Us dollar-Indian rupee (USDINR),
Pound Sterling-Indian Rupee (GBPINR) and
Japanese Yen-Indian Rupee (JPYINR).
E. INTEREST RATE FUTURES.

Interest rate futures are traded on the NSC. These are futures based on interest rates. In
India, interest rates futures were introduced on August 31, 2009.The logic of underlying
asset is the same as we saw in commodity or stock futures in this case , the underlying
asset would be a debt obligation debts that move in value according to changes in
interest rates (generally government bonds). Companies, banks, foreign institutional
investors, non-resident Indian and retail investors can trade in interest rate
futures. Buying an interest rate futures contract will allow the buyer to lock in a future
investment rate.
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FROM WEATHER TO TERROR..!!

Weather influences everyones lives. Right from daily lives to agriculture to corporate
earnings everything gets affected if the weather is not favorable. For example lets
assume that this year cold winter is expected in most parts of the United States. What
happens is that the price of heating oil goes up. Heating oil futures are traded in
commodity markets depending on weather forecasts.
The fear of terrorist strikes had even made Pentagon think of creating a futures market to
help predict terrorist strikes. Their theory was that possibility of terror strikes in a
particular area for example possibility of a terror strike in New York would be traded as
if it was a commodity. Higher the price, higher the possibilities of a terror strike. This
way they thought, would help them in finding potential threats.
Or take another example the assassination of Israel prime minister futures which
would be available for trade as a commodity. Higher the price, the more likely the event.

3. Derivatives - Futures vs. Forwards

Futures differ from forwards in several instances:

A. A forward contract is a private transaction - a futures contract is not. Futures
contracts are reported to the future's exchange, the clearing house and at least one
regulatory agency. The price is recorded and available from pricing services.
B. A future takes place on an organized exchange where the all of the contract's
terms and conditions, except price, are formalized. Forwards are customized to
meet the user's special needs. The future's standardization helps to create liquidity
in the marketplace enabling participants to close out positions before expiration.
C. Forwards have credit risk, but futures do not because a clearing house guarantees
against default risk by taking both sides of the trade and marking to market their
positions every night. Mark to market is the process of converting daily gains and
losses into actual cash gains and losses each night. As one party loses on the trade
the other party gains, and the clearing house moves the payments for the
counterparty through this process.

D. Forwards are basically unregulated, while future contract are regulated at the
federal government level. The regulation is there to ensure that no manipulation
occurs, that trades are reported in a timely manner and that the professionals in
the market are qualified and honest.

4. Characteristics of Futures Contracts

In a futures contract there are two parties:
A. The long position, or buyer, agrees to purchase the underlying at a later date or at
the expiration date at a price that is agreed to at the beginning of the transaction.
Buyers benefit from price increases.
B. The short position, or seller, agrees to sell the underlying at a later date or at the
expiration date at a price that is agreed to at the beginning of the transaction.
Sellers benefit from price decreases.
Prices change daily in the marketplace and are marked to market on a daily basis.
At expiration, the buyer takes delivery of the underlying from the seller or the parties can
agree to make a cash settlement.

C. Swap
1. Definition
A swap is a derivative in which two counterparties exchange cash flows of one party's
financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. For example, in the case
of a swap involving two bonds, the benefits in question can be the periodic interest
(coupon) payments associated with such bonds.
Specifically, two counterparties agree to exchange one stream of cash flows against
another stream. These streams are called the legs of the swap. The swap agreement
defines the dates when the cash flows are to be paid and the way they are accrued and
calculated. Usually at the time when the contract is initiated, at least one of these series of
cash flows is determined by an uncertain variable such as a floating interest rate, foreign
exchange rate, equity price, or commodity price.

The cash flows are calculated over a notional principal amount. Contrary to a future, a
forward or an option, the notional amount is usually not exchanged between
counterparties. Consequently, swaps can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices.
Swaps were first introduced to the public in 1981 when IBM and the World Bank entered
into a swap agreement.[3] Today, swaps are among the most heavily traded financial
contracts in the world: the total amount of interest rates and currency swaps outstanding
is more thn $348 trillion in 2010, according to Bank for International Settlements (BIS).
Annual value and records of trade also record by Basel 3( written as Basel III).

2. Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest
rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are
also many other types of swaps.

A. Interest rate swaps

A is currently paying floating, but wants to pay fixed.

B is currently paying fixed but wants to pay floating.
By entering into an interestR rate swap, the net result
is that each party can 'swap' their existing obligation
for their desired obligation. Normally, the parties do
not swap payments directly, but rather each sets up a
separate swap with a financial intermediary such as a
bank. In return for matching the two parties together,
the bank takes a spread from the swap payments.
The most common type of swap is a "plain Vanilla" interest rate swap. It is the exchange
of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to
over 15 years.
The reason for this exchange is to take benefit from comparative advantage. Some
companies may have comparative advantage in fixed rate markets, while other companies
have a comparative advantage in floating rate markets. When companies want to borrow,
they look for cheap borrowing, i.e. from the market where they have comparative
advantage. However, this may lead to a company borrowing fixed when it wants floating
or borrowing floating when it wants fixed. This is where a swap comes in. A swap has
the effect of transforming a fixed rate loan into a floating rate loan or vice versa.
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For example, party B makes periodic interest payments to party A based on a variable
interest rate of LIBOR +70 basis points. Party A in return makes periodic interest
payments based on a fixed rate of 8.65%. The payments are calculated over the notional
amount. The first rate is called variable because it is reset at the beginning of each
interest calculation period to the then current reference rate, such as LIBOR. In reality,
the actual rate received by A and B is slightly lower due to a bank taking a spread.

B. Currency swaps

A currency swap involves exchanging principal and fixed rate interest payments on a
loan in one currency for principal and fixed rate interest payments on an equal loan in
another currency. Just like interest rate swaps, the currency swaps are also motivated by
comparative advantage. Currency swaps entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a different currency
than those in the opposite direction. It is also a very crucial uniform pattern in individuals
and customers.

C. Commodity swaps
A commodity swap is an agreement whereby a floating (or market or spot) price is
exchanged for a fixed price over a specified period. The vast majority of commodity
swaps involve crude oil.

D. Credit default swaps

A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series
of payments to the seller and, in exchange, receives a payoff if an instrument, typically a
bond or loan, goes into default (fails to pay). Less commonly, the credit event that
triggers the payoff can be a company undergoing restructuring, bankruptcy or even just
having its credit rating downgraded. CDS contracts have been compared with insurance,
because the buyer pays a premium and, in return, receives a sum of money if one of the
events specified in the contract occur. Unlike an actual insurance contract the buyer is
allowed to profit from the contract and may also cover an asset to which the buyer has no
direct exposure.

E. Subordinated risk swaps

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or
equity holder) pays a premium to the seller (or silent holder) for the option to transfer
certain risks.
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These can include any form of equity, management or legal risk of the underlying (for
example a company). Through execution the equity holder can (for example) transfer
shares, management responsibilities or else. Thus, general and special entrepreneurial
risks can be managed, assigned or prematurely hedged. Those instruments are traded
over-the-counter (OTC) and there are only a few specialized investors worldwide.

F. Other variations
There are myriad different variations on the vanilla swap structure, which are limited
only by the imagination of financial engineers and the desire of corporate treasurers and
fund managers for exotic structures.

A total return swap is a swap in which party A pays the total return of an asset,
and party B makes periodic interest payments. The total return is the capital gain
or loss, plus any interest or dividend payments. Note that if the total return is
negative, then party A receives this amount from party B. The parties have
exposure to the return of the underlying stock or index, without having to hold the
underlying assets. The profit or loss of party B is the same for him as actually
owning the underlying asset.
An option on a swap is called a swaption. These provide one party with the right
but not the obligation at a future time to enter into a swap.
A variance swap is an over-the-counter instrument that allows one to speculate
on or hedge risks associated with the magnitude of movement, a CMS, is a swap
that allows the purchaser to fix the duration of received flows on a swap.
An Amortising swap is usually an interest rate swap in which the notional
principal for the interest payments declines during the life of the swap, perhaps at
a rate tied to the prepayment of a mortgage or to an interest rate benchmark such
as the LIBOR. It is suitable to those customers of banks who want to manage the
interest rate risk involved in predicted funding requirement, or investment
programs.
A Zero coupon swap is of use to those entities which have their liabilities
denominated in floating rates but at the same time would like to conserve cash for
operational purposes.
A Deferred rate swap is particularly attractive to those users of funds that need
funds immediately but do not consider the current rates of interest very attractive
and feel that the rates may fall in future.
An Accrediting swap is used by banks which have agreed to lend increasing
sums over time to its customers so that they may fund projects.
A Forward swap is an agreement created through the synthesis of two swaps
differing in duration for the purpose of fulfilling the specific time-frame needs of
an investor. Also referred to as a forward start swap, delayed start swap, and a
deferred start swap.

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