Based on the rights and obligations of the parties that enter into the contract, derivatives can be classified into two groups: forward commitments and contingent claims.

A forward commitment is an agreement between two parties in which one party agrees to buy and the other agrees to sell an asset at a future date at a price agreed on today. In essence, a forward commitment represents a commitment to buy or sell.

There are three types of forward commitments.

Forward Contract

A forward contract is an agreement to buy or sell an asset at a specified time in the future for a specified price.

• A forward contract is a forward commitment created in the over-the-counter market. It is not conditional; both the buyer and the seller are obliged to perform the contract as agreed.

• It is negotiated in the present and will be settled in the future. By contrast, a spot contract is settled immediately.

• The parties to the transaction specify the forward contract's terms and conditions, such as when and where delivery will take place and the precise identity of the underlying. In this sense the contract is said to be customized.

• Each party is subject to the possibility that the other party will default.

• In the financial world, the underlying asset of a forward contract can be a security (e.g., a stock or bond), a foreign currency, a commodity, an interest rate, or combinations thereof.

• The forward market is a private and largely unregulated market.

Futures Contract

A futures contract is created and traded on a futures exchange. It is a variation of a forward contract that has essentially the same basic definition but some additional features. Futures and forwards are essentially similar contracts; the principles for pricing and the applications of futures and forwards are almost identical. They differ only in the institutional settings in which they trade.

• Futures contracts always trade on an organized exchange.

• Futures contracts are always highly standardized with specified underlying goods, quantity (contract size), delivery date, trading hours and trading area. Some exchanges may specify that the contract can be only traded in a designated trading area on the floor (called a pit). For example, the Chicago Board of Trade (CBOT) establishes the following terms for the U.S. Treasury bond futures contract:
  • The contract is based on a U.S. Treasury bond with a maturity of at least 15 years.
  • The contract covers $100,000 par value of U.S. Treasury bonds.
  • The expiration months are March, June, September, and December.
  • Prices of the contract are quoted in points and 32nds of part of 100. That is, a price of 103 18/32 equals 103.5625. With a contract size of $100,000, the actual price is $103,562.50.
  • The minimum price fluctuation, or tick size, is 1/32. With a contract size of $100,000, the actual minimum size is $31.25.
  Anyone who wishes to trade a U.S. Treasury bond futures contract on the CBOT must accept these terms. If a customized contract is desired, a forward contract is the only alternative.
  Standardization of futures contracts promotes liquidity. Since futures contracts are standardized with generally accepted terms, they have an active secondary market where previously created futures contracts are bought and sold.
  • With standardized contracts, all market participants know exactly what is being offered for sale and what the transaction terms are.
  • Thus, people can quickly transact without wasting time examining contracts.
  • In addition, standardization makes it much easier for traders to find buyers and sellers.
  In contrast, forward contracts are customized and therefore usually do not trade after being created.

• Performance on futures contract is guaranteed by a clearinghouse : a financial institution associated with the futures exchange that guarantees the financial integrity of the market to all traders.
  • The clearinghouse acts as the intermediary counterparty to the buyer and seller in each trade.
  • The clearinghouse adopts the position of buyer to every seller and seller to every buyer.
  • Every trader in the futures markets has obligations only to the clearinghouse, and the clearinghouse guarantees the fulfillment of the contract of the trading parties.
  • Since the clearinghouse is well-capitalized, its default risk is very small.
  In contrast, there is no clearinghouse in a forward market. Traders in the forward market have direct obligations to each other. However, traders often do not know each other and cannot evaluate each others' credit risks, so they are concerned with the reliability of their counterparties.

• All futures contracts require that traders post margins in order to trade. The futures exchange requires traders to settle the gains/losses of their accounts on a daily basis.
  • This is called daily settlement or marking to market.
  • Every day, the gain and loss incurred by each trader is computed based on the market price of the futures contracts.
  • After the contracts are marked-to-market, funds are transferred from the traders who have sustained losses to traders who have incurred gains.
  • The practice of daily settlement is equivalent to terminating a futures contract at the end of each day and reopening it the next day at the settlement price.
  Forward contracts, on the other hand, are typically settled at expiration. Until then, no money changes hands between the counterparties.

• Futures markets are regulated by an identifiable government agency, while forward contracts generally trade in an unregulated market. Futures contracts are public transactions. A futures transaction must be reported to:
  • the futures exchanges
  • the clearinghouse
  • at least one regulatory agency
  The price of futures transactions is available to the public through price-reporting services.

• Forward contracts are generally designed to be held until expiration, but a futures market provides sufficient liquidity to permit parties to enter the market and offset transactions previously created.

Swap

A swap is an agreement between two parties to exchange a series of future cash flows.

• It is a variation of a forward contract that is essentially equivalent to a series of forward contracts.

• It is custom-tailored to meet the specific needs of counterparties, so counterparties can choose the exact dollar amount and/or maturity that they need.

• Swaps are subject to default, but as the notional principal is not exchanged, the credit risk of a swap is much lower than that of a loan.

• Swaps are private transactions and thus are not traded on exchanges and can avoid regulation to a considerable degree.

The most commonly used swap is a fixed-for-floating interest rate swap, also referred to as a "plain vanilla swap." The notional principal is the loan balance on which the interest rate payments are determined. As with futures and forwards, no money changes hands at the start of the contract, and the swap value is zero. However, as market conditions change, the value of the swap will change, being positive for one party and negative for the other.