Trading and investing via derivatives rather than direct investment in the underlying assets have become more and more popular nowadays. For brokers and banks, it is a sweet spot as most derivatives are traded OTC (over the counter) and the prices are not transparent and can not be easily compared across the board. Therefore this creates opportunities for much higher profit margins relative to traditional shares and funds. For investors and traders, these instruments give an embedded leverage which can potential multiply returns (and losses if you are on the wrong side).
A couple of weeks ago, a friend of mine was preparing for her financial markets exam and asked me to explain to her the difference between different types of derivatives (options, forwards, swaps and futures). I thought I would share this information on this here.
Options, Forwards, Swaps and Futures:
– Options = a right to exercise at predetermined price
– Forwards = an obligation to fulfill at predetermined price and date
– Swaps = an obligation to fulfill, usually exchange take place at day 1 and then swap back at a predetermined future date
– Futures = an obligation, and mark to the market
Different Types of FX Derivatives:
– Option => a right to exercise if the price is favorable
– Swap => exchange at spot rate and then exchange back at forward rate
– NDF (non deliverable forward) => instead of delivering the principal/notional amount at a future settlement date, only settle for the difference between forward rate and spot rate in the future
Different Types of Interest Rate (IR) Swaps
– IR Swap => similar to FX swap (but on interest rates) e.g. fixed vs floating, floating vs floating
– Cross Currency Swap => similar to IR swap but in different currencies.
– NDS (non deliverable swap) => same as NDF above
– Swaption => it is an option to swap rather than obligation