party. Thus, there is indeed credit risk in a swap. This risk must be managed by careful analysis before the transaction and by the potential use of such risk-mitigating measures as collateral.
There are also interest rate swaps in which one party pays on the basis of one interest rate and the other party pays on the basis of a different interest rate. For example, one party might make payments at Libor, whereas the other might make payments on the basis of the US Treasury bill rate. The difference between Libor and the T-bill rate, often called the TED spread (T-bills versus Eurodollar), is a measure of the credit risk premium of London banks, which have historically borrowed short term at Libor, versus that of the US government, which borrows short term at the T-bill rate. This transaction is called a basis swap. There are also swaps in which the floating rate is set as an average rate over the period, in accordance with the convention for many loans. Some swaps, called overnight indexed swaps, are tied to a Fed funds–type rate, reflecting the rate at which banks borrow overnight. As we will cover later, there are many other different types of swaps that are used for a variety of purposes. The plain vanilla swap is merely the simplest and most widely used.
Because swaps, forwards, and futures are forward commitments, they can all accomplish the same thing. One could create a series of forwards or futures expiring at a set of dates that would serve the same purpose as a swap. Although swaps are better suited for risks that involve multiple payments, at its most fundamental level, a swap is more or less just a series of forwards and, acknowledging the slight differences discussed above, more or less just a series of futures.
EXAMPLE 3 Forward Contracts, Futures Contracts, and Swaps
1. Which of the following characterizes forward contracts and swaps but not futures?
A. They are customized.
B. They are subject to daily price limits.
C. Their payoffs are received on a daily basis.
2. Which of the following distinguishes forwards from swaps?
A. Forwards are OTC instruments, whereas swaps are exchange traded.
B. Forwards are regulated as futures, whereas swaps are regulated as securities.
C. Swaps have multiple payments, whereas forwards have only a single payment.
3. Which of the following occurs in the daily settlement of futures contracts?
A. Initial margin deposits are refunded to the two parties.
B. Gains and losses are reported to other market participants.
C. Losses are charged to one party and gains credited to the other.
Solution to 1: A is correct. Forwards and swaps are OTC contracts and, therefore, are customized. Futures are exchange traded and, therefore, are standardized. Some futures contracts are subject to daily price limits and their payoffs are received daily, but these characteristics are not true for forwards and swaps.
Solution to 2: C is correct. Forwards and swaps are OTC instruments and both are regulated as such. Neither is regulated as a futures contract or a security. A swap is a series of multiple payments at scheduled dates, whereas a forward has only one payment, made at its expiration date.
Solution to 3: C is correct. Losses and gains are collected and distributed to the respective parties. There is no specific reporting of these gains and losses to anyone else. Initial margin deposits are not refunded and, in fact, additional deposits may be required.
This material completes our introduction to forward commitments. All forward commitments are firm contracts. The parties are required to fulfill the obligations they agreed to. The benefit of this rigidity is that neither party pays anything to the other when the contract is initiated. If one party needs some flexibility, however, it can get it by agreeing to pay the other party some money when the contract is initiated. When the contract expires, the party who paid at the start has some flexibility in deciding whether to buy the underlying asset at the fixed price. Thus, that party did not actually agree to do anything. It had a choice. This is the nature of contingent claims.
4.2. Contingent Claims
A contingent claim is a derivative in which the outcome or payoff is dependent on the outcome or payoff of an underlying asset. Although this characteristic is also associated with forward commitments, a contingent claim has come to be associated with a right, but not an obligation, to make a final payment contingent on the performance of the underlying. Given that the holder of the contingent claim has a choice, the term contingent claim has become synonymous with the term option. The holder has a choice of whether or not to exercise the option. This choice creates a payoff that transforms the underlying payoff in a more pronounced manner than does a forward, futures, or swap. Those instruments provide linear payoffs: As the underlying goes up (down), the derivative gains (loses). The further up (down) the underlying goes, the more the derivative gains (loses). Options are different in that they limit losses in one direction. In addition, options can pay off as the underlying goes down. Hence, they transform the payoffs of the underlying into something quite different.
We might say that an option, as a contingent claim, grants the right but not the obligation to buy an asset at a later date and at a price agreed on when the option is initiated. But there are so many variations of options that we cannot settle on this statement as a good formal definition. For one thing, options can also grant the right to sell instead of the right to buy. Moreover, they can grant the right to buy or sell earlier than at expiration. So, let us see whether we can combine these points into an all-encompassing definition of an option.
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
Unfortunately, even that definition does not cover every unique aspect of options. For example, options can be created in the OTC market and customized to the terms of each party, or they can be created and traded on options exchanges and standardized. As with forward contracts and swaps, customized options are subject to default but are less regulated and relatively transparent. Exchange-traded options are protected against default by the clearinghouse of the options exchange and are relatively transparent and regulated at the national level. As noted in the definition above, options can be terminated early or at their expirations. When an option is terminated, either early or at expiration, the holder of the option chooses whether to exercise it. If he exercises it, he either buys or sells the underlying asset, but he does not have both rights. The right to buy is one type of option, referred to as a call or call option, whereas the right to sell is another type of option, referred to as a put or put option. With one very unusual and advanced exception that we do not cover, an option is either a call or a put, and that point is made clear in the contract.
An option is also designated as exercisable early (before expiration) or only at expiration. Options that can be exercised early are referred to as American-style. Options that can be exercised only at expiration are referred to as European-style. It is extremely important that you do not associate these terms with where these options are traded. Both types of options trade on all continents.13
As with forwards and futures, an option can be exercised by physical delivery or cash settlement, as written in the contract. For a call option with physical delivery, upon exercise the underlying asset is delivered to the call buyer, who pays
For example, you do not associate French dressing with France. It is widely available and enjoyed worldwide. If you dig deeper into the world of options, you will find Asian options and Bermuda options. Geography is a common source of names for options as well as foods and in no way implies that the option or the food is available only in that geographical location.
