Financial Forwards / Futures

Forwards / Futures – agreements to sell a specific asset at a specified future date (the settlement date) and price (the forward price).The forward price is typically at least the current price plus the risk-free return (ie bank interest rate). If the forward price is less than this amount the seller would be better to sell at the current price and put the money in the bank.

Forwards are very commonly used as tools for reducing risk in business. Agreeing a forward contract allows a company to eliminate uncertainty in the cost of future supplies, leading to stable and predictable operational costs. For example a haulage company that is concerned about the rising cost of fuel for its fleet of lorries,may want to lock in the price at which it will buy fuel in 12 months time. While the company may lose out financially if the fuel price falls, the forward contract guarantees the settlement date and settlement price at which they will receive the fuel, and they can budget accordingly. If the fuel price rises the company will save money, as the settlement price will be lower than the market price on the settlement date.Futures are a particular type of highly tailored forwards, which are traded directly between two parties on individually negotiated terms.

Swaps – agreements between two parties to exchange one income stream against another, allowing both parties to easily spread their risk.For example a corn farmer who is concerned that his income would suffer if the price of corn dropped, may agree to swap a portion of his income stream with a beef farmer. By agreeing the swap both farmers can hedge against a drop in the value of their own product. If this happens Person A will be able to buy shares at the market price and sell them to person B at the strike price, for a profit.Derivatives themselves have a value and can be bought and sold like any other asset. Valuing derivatives is a complex field of financial mathematics. Valuations depend on the current market price of the underlying asset, the strike price, the time to expiry, any exercise restrictions, any interest or dividends to be earned while holding the position and an estimate of market volatility.

•Options – agreements giving the holder the right to buy or sell an underlying asset at a specified future date and price.A “Call” gives the holder the right to buy and a “Put” the right to sell – the underlying asset at a set “strike price” on or before the expiry date.Some employers offer stock options as part of a remuneration package, giving the employee the right to buy the company’s stock at a future date (the “exercise date”) for the current price. If the stock value rises over time (due in part to their good work) then on the exercise date the employee will have the right to buy the company’s shares at a price below the market price and can then sell the shares immediately at the market price to lock in a profit.
In a similar way two people may enter into “call” or “put” with each other. Imagine a contract giving Person A the right to sell some shares to person B at a future price. Person A does not even need to own the underlying shares to enter into the contract. Rather he/she gambles that the market price ofthe shares will fall below the strike price during the period of the contract.