Derivatives in Finance: Futures Contract, Forward Contract, Options Contracts and Swaps
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Derivatives
Derivatives are financial instruments whose value is derived from other underlying assets.
There are mainly four types of derivative contracts; they are futures, forwards, options and swaps.
However, swaps are complex instruments that are not traded in the SAARC Countries stock market.
Futures contract
This is a standardized contract between two parties to buy or sell an asset at a specified time in the future at a specified price.
Futures are standardized exchange traded contracts.
Futures’ trading is of interest to those who wish to:
Speculate by taking a view on the market and buying or selling accordingly
Prefer Price Risk Transfer through hedging
Take advantage of the leverage offered by paying a small fraction of the total contract as margin
Forward contract
A forwards contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
Since, forward contracts are not traded on a centralized exchange; they are regarded as over the counter instruments.
A forward contract settlement can occur in cash or on delivery basis.
Forward contracts are non-standardized.
It is interesting to those who wish to hedge by customizing the contract to any commodity, amount or delivery date.
Options contracts
Option contract is the most important part of derivatives contract.
An option contract gives the right but not an obligation to buy or sell the underlying assets.
The buyer of the options pays the premium to buy the right from the seller, who receives the premium with an obligation to sell the underlying assets if the buyer exercises his right.
Options can be traded in both in stock exchange and OTC market.
Options can be divided into two types; they are call and put.
Swaps
A swap is a derivative contract made between two parties to exchange cash flows in the future.
Interest rate swaps and currency swaps are the most popular swap contracts.
They are traded over the counters (OTC) between financial institutions.
These contracts are not traded on exchanges.
Generally, retail investors do not trade in swaps.
In derivative contracts, futures and options together are considered to be the best hedging instrument.
Swaps can be used to speculate the price movement and make maximum profit out of it.
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Accounting Equation |
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Basic Journal Entries in Nepali |
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Basic Journal Entries |
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Journal Entry and Ledger |
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Ledger |
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Subsidiary Book |
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Cash Book |
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Trial Balance & Adjusted Trial Balance |
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Bank Reconciliation Statement (BRS) |
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Depreciation |
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Final Account: Class 11 |
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Adjustment In Final Account |
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Capital and Revenue |
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Single Entry System |
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Non-Profit Organization (Non-Trading Concern) |
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Government Accounting |
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Goswara Voucher (Journal Voucher) |
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Futures Contract and Forward Contract
(A) Futures contract
Futures contract are standardized contracts.
They are traded on stock exchange at specified price.
They are bought or sold underlying instrument at certain date in future,
Futures contract does not carry any credit risk because the clearing house acts as counter-party to both parties in the contract.
To further reduce the credit exposure with margins, it required to be maintained by all participants all the time; for this purpose all positions are marked-to-market daily,
(B) Forward contract
Forward contract is an agreement between two parties and it is traded over-the-counter (OTC).
Forward contracts do not have such mechanisms in place.
A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future.
This is because forward contracts are settled only at the time of delivery (future time).
The credit exposure keeps on increasing since profit or loss is realized only at the time of settlement.
In derivatives market, the lot size is predefined; therefore, one cannot buy a contract for a single share in futures.
This does not hold true in forward markets as these contracts are customized based on an individual’s requirement.
Therefore, future contracts are highly standardized contracts; they are traded in the secondary markets.
In the secondary market, participants in the futures can easily buy or sell their contract to another party who is willing to buy it.
In the contrast, forwards are unregulated; so there is essentially no secondary market for them.
Differences between Future Contract and Forward Contact
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Bases |
Futures Contract |
Forwards Contract |
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Meaning |
A futures contract is a standardized contract, traded on exchange, to buy or sell underlying instrument at certain date in future, at specified price. |
A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future. |
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Structure |
Standardized contract |
Customized contract |
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Counterparty risk |
Low |
High |
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Contract size |
Standardized and fixed |
Customized and depends on the contract term |
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Regulation |
Stock exchange |
Self-regulated |
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Collateral |
Initial margin required |
Not required |
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Settlement |
On daily basis |
On maturity date |
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Share (Accounting for Share) |
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Share in Nepali |
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Debentures |
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Final Account: Class 12 |
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Final Account in Nepali |
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Work Sheet |
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Ratio Analysis (Accounting Ratio) |
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Fund Flow Statement |
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Cash Flow Statement |
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Theory Accounting Xii |
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Theory: Cost Accounting |
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Cost Accounting |
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LIFO−FIFO |
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Cost Sheet, Unit Costing |
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Cost Reconciliation Statement |
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