Derivative Contracts

Future

A futures contract is a contract to purchase or sell a specified quantity of a commodity at a stated price for delivery on a specified future date. Futures contracts are exchange-traded contracts. The only aspect of the contract that is negotiated is the price, all other terms being fixed and standardised. Under the contract, the purchaser is required to provide collateral called "margin". A futures contract can be peformed by physical performance, that is, by making or taking delivery of the underlying commodity, but it can also be terminated without physicial delivery, by way of close-out or offset, by entering into another futures contract that has rights and obligations that are equal and opposite to the rights and obligations of the contract being closed out, on a date before the date on which delivery of the underlying commodity is required to be made by the futures contract. The vast majority of futures contracts are terminated by close-out, with only a small number remaining open and requiring physical delivery of the underlying commodity.

Forward

A forward contract is an over the counter (OTC) contract for the purchase and sale of a commodity, security or other asset, for delivery on a fixed future date. The contract is custom-negotiated between the contracting parties. There are no standard terms. The purchase price of the underlying asset is specified in the contract. The contract is entered into on the assumption that the seller will deliver and the purchaser will take physical delivery of the underling asset.

Option

An option is contract is a contract entered into between two parties, under which one party - the option holder - has the right but not the obligation to purchase from or to sell to the other party - the option grantor - an identified underlying asset for a fixed price, which right is open for a specified period. The holder of the option pays the grantor an option premium, which is a non-refundable payment to the grantor for granting the option. Options fall into one of two categories: call option: an option that gives the holder the right to purchase the underlying asset, and obligates the grantor to sell the underlying asset; and put option: an option that gives the holder the right to sell the underlying asset, and obligates the grantor to purchase the underlying asset.

Swap

A swap contract can be entered into in respect of any asset or right or obligation. Certain types of swaps have become commonplace.

An interest rate swap is an agreement entered into between two parties, in terms of which the first party agrees to pay the second party, on stated dates, amounts calculated by multiplying a stated amount, called the notional principal amount, by the value of a specified interest rate index on those stated dates. The second party agrees to pay, on stated dates, which need not be the same dates on which the first party is required to make his payments, amounts that are calculated by multiplying the notional principal amount by the value of some other specified index.

A plain vanilla interest rate swap involves the exchange of the equivalent of fixed interest rate payments for the equivalent of floating interest rate payments. The party who is obligated to make the payment of the equivalent of a fixed interest rate payment, pays the same amount on each date for payment. The party who obligated to make the payment of the equivalent of a floating interest rate payment, for example, a payment based on LIBOR, EURIBOR or Bank of England base rate, calculates the payment that he is required to make by multiplying the notional principal amount by the floating interest rate on the date for payment. The payments are usually netted off against each other, with the party who is entitled to receive the difference between the two amounts being paid that difference by the other party.

A basis swap is an interest rate swap in which the parties are both required to make payments based on the value of separate interest rate indexes on a specific date. That is, the payment obligations of both parties are based on floating interest rates, so that the payment amount of each party is determined differently.

A commodity swap is a swap which is similar to a plain vanilla interest rate swap, except that the floating payment obligation is determined based on the the spot price of a commodity or the value of a commodity index (rather than an interest rate).

An equity swap is a contract under which the one party called the equity payor agrees to make periodic payments over a specified period, based on the increase in the value of a notional investment in a named equity or equity index, possibly including an amount equal to the value of dividends actually paid on the shares in question. The other party, called the floating rate payor is obligated to make periodic payments based on the decrease in the value of underlying notional equity investment, plus a specified floating rate of interest.

Swaption

A swaption is an option to put or to call a swap.

Cap

A cap is a contract that places an upper limit on an amount to be paid by one of the contracting parties. Thus an interest rate cap is a contract that places an upper limit on the interest rate to be used to calculate the interest liability of a contracting party. The contracting party who purchases a cap pays the other contracting party a fee for agreeing to honour the cap.

Floor

A floor is a contract that places a lower limit on an amount to be paid to one of the contracting parties. Thus an interest rate floor is a contract that places a lower limit on the interest rate to be used to calculate the interest entitlement of a contracting party. The contracting party who purchases a cap pays the other contracting party a fee for agreeing to honour the cap.

Collar

An collar is an agreement under which one contracting party buys a cap and sells a floor.