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Derivatives
Forward contracts may be entered into through an certain exercise or strike price, throughout the
agreement without a cash payment, provided the forward option term. The holder gains as the market price of
rate is equal to the current market rate. Forward contracts the underlying (stock price) falls below the exercise
are often used to hedge the entire price changed of a com- price.
modity, a foreign currency, or a financial instrument. irre- • An interest rate cap is an option that allows a cap
spective of a price increase or decrease.
purchaser to limit exposure to increasing interest
rates on its variable-rate debt instruments.
Futures Contracts. Futures are standardized contracts
traded on a regulated exchange to make or take delivery of • An interest rate floor is an option that allows a floor
purchaser to limit exposure to decreasing interest
a specified quantity of a commodity, a foreign currency, or
rates on its variable-rate investments.
a financial instrument at a specified price, with delivery or
settlement at a specified future date. Futures contracts Generally, option contracts are used to hedge a one-
involve U.S. Treasury bonds, agricultural commodities,
directional movement in the underlying commodity, for-
stock indices, interest-earning assets, and foreign currency.
eign currency, or financial instrument.
A futures contract is entered into through an organ-
ized exchange, using banks and brokers. These organized Swaps. A swap is a flexible, private, forward-based con-
exchanges have clearinghouses, which may be financial tract or agreement, generally between two counterparties
institutions or part of the futures exchange. They inter- to exchange streams of cash flows based on an agreed-on
pose themselves between the buyer and the seller, guaran-
tee obligations, and make futures liquid with low credit (or notional) principal amount over a specified period of
risk. Although no payment is made upon entering into a time in the future.
futures contract, since the underlying (i.e. interest rate, Swaps are usually entered into at-the-money (i.e.,
share price, or commodity price) is at-the-market, subse- with minimal initial cash payments because fair value is
quent value changes require daily mark-to-marking by zero), through brokers or dealers who take an up-front
cash settlement (i.e. disbursed gains and daily collected cash payment or who adjust the rate to bear default risk.
losses). Similarly, margin requirements involve deposits The two most prevalent swaps are interest rate swaps and
from both parties to ensure any financial liabilities. foreign currency swaps, while others include equity swaps,
Futures contracts are used to hedge the entire price commodity swaps, and swaptions.
change of a commodity, a foreign currency, or a financial Swaptions are options on swaps that provide the
instrument since the contract value and underlying price holder with the right to enter into a swap at a specified
change symmetrically. future date at specified terms (stand-alone option in a
swap) or to extend or terminate the life of an existing swap
Options. Options are rights to buy or sell. For example, (embedded option on a swap).
the purchaser of an option has the right, but not the obli- Swap contracts are used to hedge entire price changes
gation, to buy or sell a specified quantity of a particular (symmetrically) related to an identified hedged risk, such
commodity, a foreign currency, or a financial instrument, as interest rate or foreign currency risk, since both coun-
at a specified price, during a specified period of time terparties gain or lose equally.
(American option) or on a specified date (European
option). An option may be settled by taking delivery of
RISK CHARACTERISTICS OF
the underlying or by cash settlement, with risk limited to
DERIVATIVES
the premium.
The main types of risk characteristics associated with
The two main types of option contracts are call
derivatives are:
options and put options, while some others include stock
(or equity) options, foreign currency options, options on • Basis Risk. This is the spot (cash) price of the
futures, caps, floors, collars, and swaptions. underlying asset being hedged, less the price of the
derivative contract used to hedge the asset.
• American call options provide the holder with the
right to acquire an underlying product (e.g., stock) • Credit Risk. Credit risk or default risk evolves from
at an exercise or strike price, throughout the option the possibility that one of the parties to a derivative
term. The holder pays a premium for the right to contract will not satisfy its financial obligations
benefit from the appreciation in the underlying. under the derivative contract.
• American put options provide the holder with the • Market Risk. This is the potential financial loss due
right to sell the underlying product (e.g., stock) at a to adverse changes in the fair value of a derivative.
ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 197