forwards futures options swaps differences

Forwards futures options swaps are different types of derivatives contracts. Although other exotic derivative contracts are developed for trading, they are combination of  forwards, futures, options and swaps.

Comparison of  forwards futures options swaps

Forwards contracts:  Forwards contracts are privately negotiated contracts out side recognized stock exchanges. As they are private contracts they can be traded according to the needs of contracting parties. Trading is not in standardized size.  No standard rules and regulations apply to these contracts as they are not traded on the exchange. If one party defaults (counter party risk), other party has to bear the risk as no counter party guarantee is available. They are generally traded over the counter.  Both quantity and expiration date can be decided by parties as per their convenience.  As they are highly unregulated markets they are not suitable for all investors.

Futures contracts :  Unlike Forwards contracts these are traded on recognized stock exchanges and offer counter party risk guarantee (Usually exchanges assume the risk of counter party. For buyers exchanges guarantee delivery and for sellers they guarantee money). As they are traded on exchanges they have standard lot size, expiration date and can not be customized as per individual requirement.  They are subject to margins, open positions, position limits, market wide limits and other rules which are intended for stabilization and orderly functioning of derivatives markets.

Options contracts: Option contracts are two types. Call options and Put options. Call options give the buyer the right to buy the underlying contract on or before contract expiry date at pre determined price (Strike Price).  Put options give the buyer the right to sell the under lying contract on or before contract expiry date at pre determined price.  The seller has only obligation and no right in exercising the options. It means, it is the right of the buyer to decided whether to exercise his right to exercise or let the option expire.  Seller has to oblige if buyer exercises his option. In the case of call options, seller has to deliver underlying at pre determined price. In case of Put options seller has to buy underlying at pre determined price.

For Example, Investor A bought Reliance Call Option at 1000 rupees.  Before expiry date of call option, if buyer exercises his right, seller of call option has to deliver Underlying shares at 1000 rupees even current market price is more than that.  Similarly, for put options seller of put option has to buy underlying shares at 1000 rupees even if they are trading far below that price.

As can be noted, buyer will exercise his right only when there is positive cash flow upon exercise of option. Else he will let the option expired.  The maximum loss a buyer in options bears is the premium he pays while purchasing the options.  Seller has to bear unlimited loss in case the underlying moves in opposite direction.

Note: At present only cash settlement is done in Indian Exchanges. No underlying is delivered.

Swaps contracts: Swaps contracts are agreements between two private parties. These contracts are only for exchange of cash flows as per agreed formula. Settlement of cash flows takes place at a future date which is also pre determined. Usually in interest rate swaps, only interest related cash flows are swapped between the parties. In currency related swaps contracts both principal and interest are swapped between two parties as per pre agreed formula.

It should be noted that profit and loss in futures and forwards is linear. Both buyer and seller has probability of unlimited loss and profit. In options the pay off is non linear. Buyer of the option has limited loss to the extent of premium paid while seller assumes unlimited loss and his maximum gain is premium received while selling option contract.