| Updated: October 23, 2025Trading Derivative Instruments II
This lesson will cover the following
- Forward contracts and their features
- Options contracts and basic terms related to them
- Swaps contracts and currency swaps
Now, let us continue with an explanation of several other kinds of derivatives, such as forwards, options, and swaps.
Forward contracts
Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time in the future at a given price. However, unlike futures contracts, forward contracts are private agreements between two parties and are not as rigid in their stated terms and conditions.
Forward contracts have the following characteristics:
- Commercial banks provide forward contracts.
- Forward contracts are non-standardised. This characteristic indicates that you can have a forward contract for any amount of money, such as buying $154,280.72 (as opposed to being able to buy only in multiples of $100,000).
- Forward contracts imply an obligation to buy or sell currency at the specified exchange rate, at the specified time, and in the specified amount, as indicated in the contract.
- Forward contracts are not tradable.
Forward contracts trade in the over-the-counter market. They do not trade on an exchange such as the NYSE, NYMEX, or CME. When a forward contract expires, the transaction is settled in one of the following two ways. The first way is through a process known as “delivery”. Under this type of settlement, the party that is long the forward contract position will pay the party that is short the position when the asset is delivered and the transaction is finalised. While the transactional concept of “delivery” is simple to understand, the implementation of delivering the underlying asset may be very difficult for the party holding the short position. As a result, a forward contract can also be completed through a process known as “cash settlement”.
Who would use forward contracts? The non-standardised and obligatory nature of forward contracts works well for export-import firms, because they deal with specific amounts of accounts receivable or payable in foreign currency.
Forward contracts constitute one type of derivative instrument. For most investors, the concept of derivative instruments can be hard to understand. However, since derivatives are typically used by governmental agencies, banking institutions, asset management firms, and other types of corporations to manage their investment risks, it is important for investors to have a general knowledge of what these instruments represent and how they are used by investment professionals.
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Options
An option represents a contract that gives its buyer the right, but not the obligation, to buy or sell an underlying asset (a stock, a commodity, a currency pair, or an index) at a specific price on or before a certain date. It is a contract with strictly defined terms and properties.
An option is simply a contract closely related to the underlying asset. For this reason, options are known as derivative instruments, which means they derive their value from the underlying (base) asset.
Plain vanilla options (standard options), traded on options exchanges, have several features: maturity or expiry period, exercise (strike) price, and class (call options and put options).
An exercise (strike) price is the price at which the option holder can exercise his/her right to buy or sell the underlying asset.
Options that belong to the same class and have the same expiry period (maturity) are said to belong to the same series.
A call option provides the holder with the right to buy an underlying asset at the strike price within a specific period of time (maturity). Call options are similar to holding a long position in a currency pair, a stock, or a commodity. Buyers of call options hope that the value of the currency pair (or price of the stock) will increase before the option expires.
The buyer can always let the expiry date pass, at which point the option itself becomes worthless. In this case, the buyer loses 100% of the investment (the premium paid for the option).
A put option provides the holder with the right to sell an underlying asset at the strike price within a specific period of time (maturity). Put options are similar to holding a short position in a currency pair, a stock, or a commodity. Buyers of put options hope that the value of the currency pair (price of the stock) will decline before the option expires.
When trading options, individuals who purchase options are known as holders, while individuals who sell options are known as writers.
It is extremely important that we clarify the following point.
Call option holders and put option holders (or buyers) are not obliged to buy or sell the underlying asset. They simply have the choice whether to exercise their rights or not. Call option writers and put option writers (or sellers), on the other hand, are obliged to buy or sell the underlying asset. This means that they may be required to honour their promise to buy or sell.
When we refer to call options, these options are said to be in-the-money when the price of a share (value of a currency pair) exceeds the strike price. This means that we can make a profit by trading such an option. When we refer to put options, these options are said to be in-the-money when the price of a share (value of a currency pair) remains below the strike price.
The amount by which an option is in-the-money is referred to as the option’s intrinsic value. An option can be deep in the money, meaning it is highly profitable and unlikely to result in a loss.
If the price of a share (value of a currency pair) matches the strike price, options are said to be at-the-money.
When we refer to call options, if the price of a share (value of a currency pair) remains below the strike price, these options are said to be out-of-the-money. This means that it is not profitable to take action (exercise our rights), because exercising it would result in a loss. When we refer to put options, if the price of a share (value of a currency pair) exceeds the strike price, these options are said to be out-of-the-money. An option can also be deep out of the money, representing a large unrealised loss, and is unlikely to become profitable.
Options can also be categorised as European and American options. European options can be exercised only on the maturity date. American options can be exercised at any time before expiry.
An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These options have fixed strike prices and expiry dates. Each listed option represents 100 shares of a company’s stock, and is referred to as an option contract.
The total price of an option is known as a premium. It usually depends on a number of factors such as the price of the underlying asset, the exercise (strike) price, the period of time remaining before maturity (also known as time value), and volatility.
Why do investors use options? First of all, for speculation. We have already discussed the matter of speculating in the markets. Options are considered risky exactly because they can be used for speculation. If a trader purchases an option, the trader needs to be precise not only in determining the direction of the price movement (in stocks or currency pairs), but also its extent and timing. The trader must correctly anticipate not only whether the price of the underlying asset will increase or decline, but also by how much and within what period this could occur.
Another reason to use options when speculating in the markets is, of course, the ability to employ leverage. For example, if a trader holds one contract representing 100 shares, they could realise a considerable profit without the price moving very far.
Secondly, options can be used for hedging. In this case, traders use options to safeguard their positions against a possible downturn. If a trader wishes to benefit from a company’s stock that has the potential to rise, they will also want to secure their investment against downside risk.
Swaps
A swap is a derivative instrument through which counterparties exchange the cash flows of one party’s financial instrument for those of the other party’s financial instrument. The two parties agree to exchange one stream of cash flows for another, with these streams being known as the legs of the swap. The swap agreement sets the dates on which the cash flows are due and how they are calculated.
When we talk about a currency swap, we mean exchanging principal and fixed-rate interest payments on a loan in one currency for principal and fixed-rate interest payments on an equivalent loan in another currency. These swaps focus on comparative advantage. Currency swaps involve exchanging both principal and interest between the parties, with the cash flows in one direction being denominated in a different currency from those in the opposite direction.
There are many other varieties of swaps, but because swap trading has its own specific features, it remains outside the scope of this tutorial.