Contracts

Contracts

·         An agreement to do something future.

·         Values of contracts depend on the value of underlying assets like commodities, a security and index that represents values of another instrument.

·         Provide physical or cash settlement

o   Physical items like tomato, pork bellies, gold bars, delivery of petroleum, lumber. It could be delivery of financial instrument like bonds, equities. Delivery can be electronic.

o   Cash contracts settle through payment depend on contract formulas such as interest rate, stock indices, credit default swaps

o   Immediate contracts: call for immediate delivery in three or less days at spot market.

o   Futurity: term for all other contracts.

Forward contracts

·         An agreement to trade the underlying asset in the future at a price upon today. E.g. Farmers and flour manufacturer. It reduces risk for both sides so that it is called hedgers.

·         Counterparty risk: other party to a contract will fail to honor the terms of the contract due to large price changes. Mostly longstanding relationship with each other execute forward contracts.

·         In case, liquidity of both parties must be good so that the delivery will be economically efficient and quite certain.

Futures contracts

·         A standardized forward contract for which a clearinghouse guarantees the performance of all traders which leads to succession of delivery from both sides.

·         Clearinghouse: an organization which ensures that no trader is harmed. If the contract fails, one or both sides eliminate their obligation, in this situation clearinghouse is buyers from seller and conversational.

·         Initial margin: A required amount that all participant posts with clearinghouse to protect against default at the time of entering contracts. Loss and profit margin are deducted by clearinghouse from that amount.

·         Maintenance margin: amount that posted by participants. If margin drop below Mm, then the trader must replenish their accounts. If he fails, then broker of trader trade to offset the participant's position.

·         This variation margin payment ensures that liability will not grow.

·         Benefit: reduces counterparty risk with improved efficiency. Traders can close their position by arranging offset trades at the same time they enter in spot market and make or take ultimate delivery.

Swap contracts

·         An agreement to exchange, payment of periodic cash flows that depend on future asset price or interest rate, e.g. Interest rate swap, at periodical interval, one party makes cash, fixed payment to the counterparty in exchange for variable cash payment from the counterparty.

·         The variable payment is based on pre specified variable interest rate such as London interbank offered rate. This swap effectively exchange, fixed interest payment for variable interest payment because the variable rate is set in the future, the cash flow in this contract is uncertain when parties enter the contracts.

·         Investment manager often enters interest rate swaps when own long term income streams that they want to convert cash flow that varies with current short term interest rates or vice versa. The conversion may allow them to substantially reduce the total interest rate risk to which they exposed. Hedger often uses swap contracts to manage risks.

·         Can be commodity swap, currency swap, equity swap.

Option contract:

·         Allows the holder of the option to buy or sell, depending on the type of the option, an underlying instrument at a specified price or before specified date such as individual stocks, stock indices, future contract, currencies, and swaps. Option contracts does not impose any liability. Institution trade many customize option contracts with a dealer in the over-the-counter derivative market.

·         Buy or sell are called exercise. Buy is called a call option and sell is called put option. Specific price is called strike price or exercise price. They use this option depend on the market price of the underlying instrument.

·         European-style contracts: exercise only when contracts are mature. American-style contracts: exercise the contracts early.

·         Option premium: price that the trader pays for the option

·         Writer of an option must trade the underlying instrument if the holder exercise the option.

Other contracts:

·      Insurance contract: pay the beneficiary a cash if an event occurs, e.g. Life, liability, automobile insurance. These could be bought directly from companies or already issued from owners

·      Credit default swaps: to convert risky bonds to more secure investment. An insurance that promises the payment of principle in the event that a a company default on its bond. A trader who believes that a corporation will default on its bonds may buy credit default swaps written on the corporation’s bond if the swap prices are low.

·      Insurance helps in taxation