Financial Instruments and Markets: A Casebook

14

Note on Forward Contracts and Swaps

Forward contracts and swaps are among the most common examples of financial derivatives. A derivative is a financial instrument whose value depends on another product (known as the underlying), which can be financial (such as bonds or currencies) or physical (such as wheat, oil or other commodities). The underlying of a forward contract is an asset of some sort, and the contract specifies the delivery of that asset at a fixed time in the future at a certain price between the parties of the contract. Farming companies, for instance, use forward contracts to fix a price for their upcoming crop before the crop has been harvested. As to swaps, the underlying is normally a financial instrument, such as interest rates, currencies or a financial index. In its most basic form, a swap is an agreement in which two counterparties agree to exchange future cash flows. The cash flows are determined by the performance of the underlying. This can be done, for instance, to transform a floating-rate loan into a fixed-rate or vice versa.

When discussing “forwards,” a related term that often appears is “futures.” Although similar in many aspects, the two derivatives differ in one key aspect. While forward contracts are settled at their expiration, futures are settled every day during the lifespan of the contract. In this note, for simplicity, we will not distinguish between forwards and futures, but will use the term “forward contract” exclusively.¹

FORWARD CONTRACTS ...