Question

Consider futures, forwards, options and swaps. Which derivative is the least risky choice for a risk averse public company? Why?

Answer 1

Among financial derivatives there are several instruments that may seem similar, but can potentially result in significant losses if not properly distinguished from each other. Swaps, Forwards and Futures are an example of this. They all have in common that they can be used to help organizations and individuals to hedge against risks, or be used for speculative purposes instead. Another thing they have in common is that they are now all making their way to Bitcoin markets. With Swaps and Futures already covered extensively before, the below will quickly recap the definitions.

Definitions

A Swap contract is a contract in which parties agree to exchanging variable performance for a certain fixed market rate. In short, parties agree to exchanging cash flows on a future date. For Bitcoin this can either be fixed-floating commodity swaps or commodity-for-interest swaps

Futures Contracts or simply Futures are nothing more than an agreement between two parties to buy or sell a certain commodity (or financial instrument) at a pre-determined price in the future. Positions are settled on a daily basis.

Also Forwards come down to making an exchange at a future date. The agreements include delivering a certain amount of goods (or financial instruments) by the end of a certain period.

Futures and Forwards

The definitions should make clear why there can be confusion surrounding these derivatives. Every contract type involves an agreement to make an exchange at a certain pre-defined future date. Given the nearly identical description, Futures and Forwards are the most similar contracts.

Assume Alice and Bob enter into a Forward contract where they agree to exchange 1 Bitcoin at the current price of $10,000 three months from now. Bob is the seller and thus has a short position, while Alice the buyer and therefore has a long position. If the actual price of Bitcoin rises to $11,000 by the end of the contract, it would mean a loss of $1,000 to Bob. Bob has to deliver 1 Bitcoin, which he has to buy for $11,000, for which he’ll only receive the agreed price of $10,000. On the other hand, Alice will have a profit of $1,000. She gets 1 Bitcoin for the agreed price of $10,000, while it is worth $11,000. This is the final outcome for both the Forward and Futures contract at the expiry date.

The key difference between Futures and Forwards is in the fact that Futures are settled on a daily basis and Forwards are not. If prices move to $11,000 per Bitcoin the next day, then the gains and losses would be immediately credited or deducted. This is why margin requirements apply for Futures trading. For Forwards, nothing happens until maturity. Therefore, the intermediate gains and losses can never be greater than the final value.

If prices would move to $12,000 per Bitcoin before the end of the Futures Contract, Bob would see $2,000 deducted from his account while the Alice would receive $2,000. Even if the price ends at $11,000 per Bitcoin, Bob will have to meet the margin requirements while the price is at $12,000 per Bitcoin. This is why Futures Contracts mean increased liquidity risks compared to Forwards, where only the final value matters. If Bob cannot meet the margin requirements, his positions could be force-closed and leave him with a bigger realized loss then would otherwise be the case at the end of the contract (where the price is back at $11,000).

Because there is no daily settlement in Forwards, there is less such liquidity risk but increased counterparty risk instead. Margin requirements provide a guarantee that the counterparty will able to pay by the end of the contract, as accounts are adjusted every day. Forward contracts are typically negotiated directly between two parties as a result, while Futures are suitable to be quoted and traded on exchanges in standardized form.

Swaps and Forwards

A Swap contract compares best to a Forward contract, although a Forward has only a single payment at maturity while a Swap typically involves a series of payments in the futures. In fact, a single-period Swap is equivalent to one Forward contract.

Option Contracts:
An option contract is a contract which gives one party the right to buy or sell the underlying asset on a future date at a pre-determined price. The other party has the obligation to sell/buy the underlying asset at this pre-determined price (called the strike price). The option which gives the right to buy is called the CALL option while the option which gives the right to sell is called the PUT option. Let us consider a few examples: -

i)Buyer of Nifty July Call option of strike 4500: It gives the right to buy Nifty at 4500

ii) Buyer of Infosys July Put option of strike 1550: It gives the right to sell Infosys at 1550

iii) Seller of Nifty July Call option of strike 4500: The seller has the obligation to sell Nifty at 4500

iv) Seller of Infosys July Put option of strike 1550: The seller of the Put option has the obligation to buy Infosys at 1550

It is to be noted that the right always remains with the buyer of the option while the seller of an option always has the obligation. In return, the buyer pays the seller a premium for getting the right. This premium is the maximum possible loss for the buyer and the maximum possible gain for the seller. We will discuss options in much greater details in later publications.

In my opinion, forward contracts are less riskier choice for public co. Because the prices are set by an agreement between the parties to cover the risks from both sides.