Question

QUESTION 1 a) What is a derivative security? b) What are the differences among a spot contract, a forward contract, and a futures contract? c) What is an option? How does an option differ from a forward or futures contract? What is the difference between a call option and put option? d) What is a swap? What is the difference between an interest rate swap and a currency swap? e) Which party is the swap buyer and which is the swap seller in an interest rate swap transaction?

Answer 1

a). A derivative security is a security which acquires it value from other underlying asset. There are various types of derivatives such as swaps, options, futures and forwards. A convertible bond issues by a company is an example of derivative security.

b). A spot contract is a contract which is entered today and which is settled today itself. It means both delivery and settlement takes on the same day. Typically the spot contract is settled within 2 business days.The rate at which the spot contract is settles is called spot rate.

In contrast a forward contract and a future contract is entered today but for a later date and a future price. Difference between forward contract and future contract are as follows:

1. Forward contract can be customized as per requirement where as a future contract is a standard contract.  

2. Forwards contract are self-regularized whereas future contracts are governed by stock exchange.

3. Forward contracts generally do not require any initial payment while future contracts require initial margin payment.

c). An option contract is entered between parties which allows the buyer of option to exercise certain rights in relation to purchase or sale of security as per his/her own will depending upon future circumstances. For acquiring an option, option buyer has to pay an option premium to option seller.

Unlike forward or future contract the option buyer has no liability to honor the contract. He/she can simply choose not to exercise an option.

A call option is a right to buy a security (generally stocks/shares) whereas a put option is a right to sell a security both at a predefined future date and a predefined price.

d). A swap is typically a contract between two parties where they share each others cash flow requirements or liabilities in order to achieve an overall benefit to both the parties.

Interest rate swap involves exchanging each other interest payment obligations wheres currency swap means exchange of a particular amount of money in one currency for same amount of money in other currency.

e). The party which swaps the fixed rate payment is called as swap buyer whereas the party which swaps the floating rate payment is called as swap seller.