InvestorQ : Can you explain the difference between forwards, futures, options and swaps?
Nishant Chandani made post

Can you explain the difference between forwards, futures, options and swaps?

Dilmini Mercia answered.
3 years ago

Derivatives are so flexible that there are many permutations and combinations in derivatives and the users are free to structure the products as they wish. However, if we were to broadly sum up the derivatives piece, then it would be restricted to just four products these are the four most popular categories of derivative contracts in the market. Let us look at each of them in some detail.

Firstly, a forward contract is an agreement to buy or sell an underlying asset at a future date at a fixed price. The price and the date of delivery are decided in advance. Such contracts are not regulated by any exchange and are only governed by the Indian Contacts Act. Also, forwards are not standardized and are unique to two parties. Since they are unique, they are also not listed on the bourses.

Futures are structurally like a forward contract but there are 2 key differences between the two in terms of execution. Firstly, futures are standardized in terms of lot sizes, strike prices etc. This makes them a more liquid compared to forwards since a ready secondary market can be found at any point of time. Secondly, futures are traded on a stock exchange and cleared through the clearing corporations. Thus all trades are guaranteed by the clearing corporation and hence there is no risk of default. This is one area where futures really score over forwards.

Thirdly, options are slightly different from futures and forwards. Both futures and forwards are symmetric contracts; meaning losses and profits for the buyer and the seller can be unlimited. In case of options, the contract is asymmetric. For the buyer, the returns are unlimited but the risk is limited. In the case of seller of option, the return is limited to the premium but the risk is unlimited. It is this asymmetry that makes options very attractive from a hedging and non-directional trading perspective.

Swaps don’t really exist in India in a big way. They entail an exchange of one set of flows for another. You can swap the cash flows of fixed rate bond for floating rate bond and vice versa or dollar flows for Yen flows. Swaps are not used in Indian markets in a big way