What‘s it: A contract is a legally enforceable agreement between two or more parties. A contract establishes a relationship between the parties who agree to do or refrain from doing some act now or in the future. A contract may also specify how arbitration or legal action will resolve any dispute over its interpretation.
Financial markets do not only trade equities and debt securities. However, there, you can also trade contracts, mainly for hedging. Examples are futures, forward, swap, and option contracts.
You can also purchase credit default swaps (CDS) to protect yourself from unexpected losses when investing in the debt market. CDS allows you to trade or offset your credit risk with other investors.
Contract settlement may involve physical delivery as in commodity contracts. Or it is settled in cash.
What is a contract worth?
A contract in financial markets is valuable because there is an underlying asset. The underlying assets may be securities such as stocks or bonds. Alternatively, they are commodities, interest rates, or an index such as the S&P 500.
Thus, a contract derives value from – and therefore depends on – the underlying asset’s value. And it is dynamic. The underlying asset may change in value before the contract expires, which exposes investors to risk and potential.
For example, you take out a call option contract for a stock because you expect its price to rise. However, if the price actually falls in the future, you are at a loss.
What are the types of contracts in financial markets?
There are several ways to classify contracts. For example, they are grouped into:
- Financial contract. The arrangement uses a financial asset such as equity securities as the underlying asset.
- Physical contract. The contract uses a physical asset, such as a commodity, as the underlying asset.
Then, another classification groups contracts based on when they will be settled.
- Contracts with immediate settlements
- Contracts with future settlements
We call a contract with immediate settlement a spot contract. Completion is immediate, usually taking three days or less.
Contracts with a future settlement include futures and forward contracts. Swap and option contracts are other examples. The contract requires settlement to be made in the future. Delivery is made after three or more days, like a three-month or six-month futures contract.
What are examples of contracts in financial markets?
In this section, we will exclude spot contracts. We will focus on futures, forwards, options, and swaps.
There are also insurance contracts. They allow investors to protect themselves against unforeseen risks. An example is credit default swaps (CDS), which will enable you to get paid when the bonds you hold default. Unfortunately, we will also exclude such contracts.
Forward contracts specify obligations to buy and sell the underlying asset in the future. They are suitable for hedging or speculation.
If you are a buyer, you are in a long position, profiting if the price increases. Meanwhile, your opponent is in a short position, benefiting if the price drops.
Unlike futures contracts, forward contracts are unstandardized. So, the specifications can be adjusted to your needs. In addition, contracts are traded over the counter (OTC), where negotiations occur between transacting parties and not through exchanges.
Futures contracts are similar to forward contracts. It represents an obligation to buy or sell the underlying asset in the future.
However, unlike forward contracts, futures contracts are standardized and traded on organized exchanges. So, quantity, price, and settlement date are predetermined.
You can find them on well-known futures exchanges such as the CME Group, including the Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX), Commodity Exchange Inc. (COMEX), and others.
In addition, their trade also involves a clearing house. When the buyer and seller match, the agency acts as a partner for trade settlement. Thus, its presence mitigates risks such as counterparty default and promotes market efficiency and price transparency.
Swaps are derivative contracts to exchange a series of cash flows of different financial instruments at periodic settlement dates over a specified period. We can view it as a series of futures contracts. Examples are interest rate swaps and currency swaps (FX Swaps).
Swaps involve over-the-counter trading. For example, the vanilla swap is the most commonly traded interest rate swap in the fixed-income market. Investment banks and commercial banks usually act as swap market makers.
For example, under a vanilla swap, investment banks offer contracts to clients such as investors, corporations, or banks.
Swaps help clients match their assets or liabilities. For example, corporations issue bonds with floating interest rates.
If they expect future interest rates to rise, companies enter into swaps to help them pay a fixed rate. Thus, it can minimize future interest payments.
Meanwhile, bondholders may also enter swaps to receive floating-rate payments for their fixed-rate debt securities. Floating interest rates are more profitable than receiving fixed interest payments because interest rates are expected to rise.
Option contracts represent the right for the holder to buy or sell an asset at an exercise price at some time in the future. Thus, they only give the holder rights, not obligations, as – and therefore, in contrast to – futures or forward contracts.
There are two option contracts:
- Call option
- Put option
Call options give the holder the right to buy. Whereas a put option gives them the right to sell.
Put options are profitable when the underlying asset drops in price. Meanwhile, call options are profitable when the price rises.
For example, a stock is trading at $100. You expect the price to go above $120 in the next three months.
You then enter an options contract by buying a call option at an exercise price of $110, and it will be exercised two months from today. You also pay a $5 premium.
After two months, the share price rose to $130. You then exercise the call option and buy the stock at $110.
After holding the stock, you realized a profit by selling the stock at $130. So, you made a profit of $15 = $130 – $110 -$5.
If the opposite condition occurs, the call option will be profitable. You expect the price to go down. You then buy the put option at an exercise price of $90 and a premium of $5.
After two months, the price drops to $80. You buy the stock by paying $80. You then exercise a call option and sell it at $90. After deducting the premium, your profit is $5 = $90 – $80 – $5.
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