A contract is an agreement among traders to do something in the future. Contracts include forward, futures, swap, option, and insurance contracts. The values of most contracts depend on the value of an underlying asset.
The underlying asset may be a commodity, a security, an index representing the values of other instruments, a currency pair or basket, or other contracts.
Contracts provide for some physical or cash settlement in the future.
In a physically settled contract, settlement occurs when the parties to the contract physically exchange some item, such as avocados, pork bellies, or gold bars.
Physical settlement also includes the delivery of such financial instruments as bonds, equities, or futures contracts even though the delivery is electronic. In contrast, cash settled contracts settle through cash payments. The amount of the payment depends on formulas specified in the contracts.
Contracts that call for immediate delivery are called spot contracts, and they trade in spot markets. Immediate delivery generally is three days or less, but depends on each market. All other contracts involve what practitioners call futurity. They derive their values from events that will take place in the future.
Forward Contracts
A forward contract is an agreement to trade the underlying assets in the future at a price agreed upon today.
Practitioners call such traders hedgers because they use their contractual commitments to hedge their risks.
Forward contracts are very common, but two problems limit their usefulness for many market participants. The first problem is counterparty risk.
Counterparty risk is the risk that the other party to a contract will fail to honour on terms of the contract.
The second problem is liquidity. Trading out of a forward contract is very difficult because it can only be done with the consent of the other party. The liquidity problem ensures that forward contracts tend to be executed only among participants for whom delivery is economically efficient and quite certain at the time of contracting so that both parties will want to arrange for delivery.
Futures Contracts
A futures contract is a standardised forward contract for which a clearinghouse guarantees the performance of all traders.
The buyer of a futures contract is the side that will take physical delivery or its cash equivalent. The seller of a futures contract is the side that is liable for the delivery or its cash equivalent.
A clearinghouse is an organisation that ensures that no trader is harmed if another trader fails to honour the contract.
In effect, the clearinghouse acts as the buyer for every seller and as the seller for every buyer. Buyers and sellers, therefore, can trade futures without worrying whether their counterparties are creditworthy. Because futures contracts are standardised, a buyer can eliminate his obligation to buy by selling his contract to anyone. A seller similarly can eliminate her obligation to deliver by buying a contract from anyone. In either case, the clearinghouse will release the trader from all future obligations if his or her long and short positions exactly offset each other.
To protect against defaults, futures clearinghouses require that all participants post with the clearinghouse an amount of money known as initial margin when they enter a contract. The clearinghouse then settles the margin accounts on a daily basis. All participants who have lost on their contracts that day will have the amount of their losses deducted from their margin by the clearinghouse. The clearinghouse similarly increases margins for all participants who gained on that day. Participants whose margins drop below the required maintenance margin must replenish their accounts. If a participant does not provide sufficient additional margin when required, the participant’s broker will immediately trade to offset the participant’s position. These variation margin payments ensure that the liabilities associated with futures contracts do not grow large.
Swap Contracts
A swap contract is an agreement to exchange payments of periodic cash flows that depend on future asset prices or interest rates.
In a typical interest rate swap, at periodic intervals, one party makes fixed cash payments to the counterparty in exchange for variable cash payments from the counterparty.
The variable payments are based on a pre-specified variable interest rate such as the Secured Overnight Financing Rate (SOFR).
In a commodity swap, one party typically makes fixed payments in exchange for payments that depend on future prices of a commodity such as oil.
In a currency swap, the parties exchange payments denominated in different currencies. The payments may be fixed, or they may vary depending on future interest rates in the two countries.
In an equity swap, the parties exchange fixed cash payments for payments that depend on the returns to a stock or a stock index.
Option Contracts
An option contract allows the holder (the purchaser) of the option o buy or sell, depending on the type of option, an underlying instrument at a specified price at or before a specified date in the future.
Those that do buy or sell are said to exercies their contracts.
An option to buy is a call option, and an option to sell is a put option.
The specified price is called the strike price (exercise price).
If the holders can exercise their contracts only when they mature, they are European-style contracts.
If they can exercise the contracts earlier, they are American contracts.
Many exchanges list standardised option contracts on individual stocks, stock indexes, futures contracts, currencies, swaps, and precious metals. Institutions also trade many customised option contracts with dealers in the over-the-counter derivative market.
Other Contracts
Insurance contracts pay their beneficiaries a cash benefit if some event occurs. Life, liability, and automobile insurance are examples of insurance contracts sold to retail clients. People generally use insurance contracts to compensate for losses that they will experience if bad things happen unexpectedly. Insurance contracts allow them to hedge risks that they face.
Credit default swaps (CDS) are insurance contracts that promise payment of principal in the event that a company defaults on its bonds. Bondholders use credit default swaps to convert risky bonds into more secure investments. Other creditors of the company may also buy them to hedge against the risk they will not be paid if the company goes bankrupt.
Well-informed traders who believe that a corporation will default on its bonds may buy credit default swaps written on the corporation’s bonds if the swap prices are sufficiently low. If they are correct, the traders will profit if the payoff to the swap is more than the cost of buying and maintaining the swap position.
