Derivatives: Forwards, Futures, Options and Swaps
Four instruments, one logic
Derivatives questions reward candidates who can map each instrument to its obligation structure. A forward is a private, customised obligation to trade at a future date. A futures contract is a standardised, exchange-traded forward with daily mark-to-market and a clearing house between counterparties. An option confers a right, not an obligation, and the buyer pays a premium. A swap exchanges cash flows over time, most commonly fixed for floating.
Concepts to master
Understand the payoff profiles of long and short forwards, calls, and puts. Know the difference between intrinsic value and time value, and the factors that drive option premiums: underlying price, strike, time to expiry, volatility, and rates. Understand margin in futures versus collateral in bilateral derivatives, and the role of central clearing. Know the concept of counterparty credit risk and how netting and collateral agreements mitigate it. Understand the difference between hedging, speculation, and arbitrage.
Traps
A common trap is assuming an option buyer faces margin calls; the buyer's maximum loss is the premium, while the writer faces margin. Another trap is confusing the obligation to deliver under a forward with the right to exercise an option. Watch for questions on futures where the candidate forgets daily settlement - gains and losses are realised daily, not only at expiry. Also watch for the difference between physical and cash settlement.
Worked example
A client buys a call with a strike of 50 for a premium of 3. At expiry the underlying is 56. The intrinsic value is 6, so the net profit is 3. At an underlying price of 52, the intrinsic value is 2, so the net loss is 1. Break-even is 53. Any answer that ignores the premium is wrong.
Rule of thumb
Options: buyer pays premium, writer posts margin. Forwards and futures: both sides carry obligation, but only futures settle daily.