Question

Forwards, futures and options have been used by financial institutions for many years to hedge risk before swaps were invented. If a financial institution already had these hedging instruments, then why they need swaps? In your answer please include a discussion of the differences and similarities of: forwards, futures, options and swaps.

Answer 1

Swaps dominate the market where a series of payments are exchanged between the two parties. Swaps are not traded on the exchanges , due to which it is not standarized but customised contracts.

Swaps are used to hedge interest rate risks, currency risk and commodity risk and credit default swap. People enter into the interest rate swaps, where they exchange either fixed for fixed, fixed for floating or floating for fixed payments.

Futures are standarized contracts, which is regulated by an exchange. The exchange acts like a guarantor between the two parties and protects the parties from counterparty default risk. When a person enters into a future contract, it is an obligation to buy the specific product at the price that it has decided upon today irrespective of the price that exists at the future date.

Forwards also allows the parties in a contract to enter into an agreement , to purchase the security at a price that is agreed upon today, irrespective of the price movements in the future. These contracts are not regulated as is subject to counter[party default risk.

Options gives, the option holder a right but not an obligation to purchase a particular security at the strike price. IN options , the buyer has to pay a premium to buy the option and if he does not exercise his option , he will lose the amount of premium,

Futures, forwards and options all trade on an underlying security but swaps do not.