Lesson 3 of 8 · All lessons in this module
- What the financial system does, and what makes it work well
- Classifying assets and markets: securities, pooled vehicles, currencies, commodities and real assets
- Contracts: forwards, futures, swaps, options and insurance
- Financial intermediaries and the services they provide
- Long, short and leveraged positions: leverage ratio, margin return and margin callsVideo lesson
- Orders: execution, validity and clearing instructionsVideo lesson
- Integrated cases: a leveraged loss, a hedge with a floor and a stop-limit buy
- Primary markets, secondary markets and how trades are arranged
Lesson 3 of 8 · 14 min
Contracts: forwards, futures, swaps, options and insurance
Contracts are agreements to do something later; forwards lock in a price but carry counterparty and liquidity problems, futures fix both with standardisation and a clearinghouse, swaps repeat the exchange, and options give a right rather than an obligation.
In short
- Contracts settle physically (the item is delivered) or in cash; they are classed physical or financial by their underlying.
- A forward fixes today the price of a later trade; its two weaknesses are counterparty risk and illiquidity.
- A futures contract is a standardised forward whose performance a clearinghouse guarantees; traders post initial margin, are settled daily, and must top up to initial margin if the account falls below maintenance margin.
- A swap exchanges a series of periodic payments; a cash-settled forward has a single payment.
- An option gives the holder the right to buy (call) or sell (put) at the strike price; the writer must perform. Insurance and credit default swaps pay when a loss event occurs.
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