A forward contract or ‘forward’ is an agreement between two parties, wherein one will sell an asset to the other on a certain future date at an agreed price. The quantity and quality specifications of the asset and place of delivery are mutually decided while entering into the agreement.

Essentially, the agreement takes place after a one-to-one negotiation between the buyer and the seller and hence, forward contracts offer a lot of flexibility in terms of duration of the contract, quality and quantity of assets and so on.

Illustration
Suppose you plan to sell your house to a friend for Rs 50 lakh one year down the line for which you enter into a contract today. In this case the asset sold is unique, the price is fixed and so is the date of delivery. This amounts to a forward contract.

 
As Forward contracts are negotiated on a one-to-one basis, they offer a high degree of flexibility in terms of price, quantity and delivery time. However their drawbacks are poor liquidity (as they are customised/unique to the two parties in the contract, they cannot be traded with any other party) and default risk (either of the parties could fail to fulfil their obligations).

In India, forward contracts are regularly used in the foreign exchange markets to hedge currency risk and in the commodities market to hedge price risk.

Futures contracts or ‘futures’ are an improvement over forward contracts as they are standardized and tradable. A futures contract is a legal agreement between a buyer and a seller and both parties are bound to uphold the agreement. As per the contract, the seller agrees to sell a specific asset to the buyer at an agreed price on a particular date in the future. The contract specifies quantity, quality, delivery time, place and date of delivery.

Futures contracts are highly liquid since they are standardized (i.e. all contracts are structured so that they conform to certain combinations of parameters in terms of quality, quantity, expiration date, etc.) and can be traded on an exchange. Besides, there is no counter party risk or risk of default, as a clearing corporation or clearing house assumes this risk. In fact, in a futures contract you are unlikely to even know your counter party, just as is the case with buying or selling stocks through a stock exchange. The clearing corporation plays a crucial role as it takes care of transaction processing and settlement and also guarantees trades. Further, as futures contracts are standardized and liquid, price discovery is far better than in the case of forward contracts, where direct negotiation takes place between two parties.

The commodity futures market like the Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX), National Multi-Commodity Exchange (NMCE) and the index and stock futures segment of the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are some examples of futures markets.

One of the critical similarities between a forward and futures contract is that in both cases, buyers and sellers are exposed to an unlimited risk associated with the price. However, you can limit your risk by buying options as explained below.

An option is a contract where the writer of the option grants the buyer of the option the right to purchase from (call option) or sell to (put option) him a specific asset at a specific price within a specified period. In return the buyer of the option (also called the option holder) pays a price called an option premium to the writer for this right. In common market parlance, the writer of the option is also called the ‘seller’ of the option. 

The option seller has the obligation to honour the contract, whether he is required to sell or buy the asset, if the buyer chooses to exercise his option to buy or sell. The potential downside or risk for the option seller is unlimited, while his upside or profit is limited to the premium that he receives. On the other hand, the maximum loss that the buyer could face is the option premium that he pays, but his potential profit is unlimited.

A warrant is a call option, which gives you the right (but you are not obliged) to buy a predetermined number of equity shares within a stipulated time frame at an agreed price. Normally, a nominal margin of about 10 per cent of the agreed price, is payable when warrants are subscribed by the investor.

The important difference between a normal call option and a warrant is that warrants are for a longer duration (1 to 5 years) as against the duration of a call option which is usually only a few months (normally up to 3 months in the case of stock options on the NSE and BSE).

Warrants are normally issued by companies for the benefit of a certain class of shareholders (i.e. promoters or institutional investors) or to raise capital over a period of time or reduce interest cost (by attaching warrants to debt instruments).

 
What makes warrants attractive to an investor is that he acquires the right to convert the warrant into equity shares at a predetermined price at a future date. Instead of investing the full amount in buying a share, a warrant investor pays a nominal margin (about 10 per cent) and will exercise his right to convert into a share (and pay the difference between agreed price less margin) only if the market price of the share at that time is higher than the agreed price. Conversely, in case the market price is lower than the agreed price, the investor is not obligated to exercise the warrant and will simply allow the warrant to lapse. However, the margin paid would be forfeited by the company in this case.

Furthermore, since warrants are usually tradable, a warrant holder is not bound to hold this instrument until it becomes exercisable. He can sell his warrants by selling them on the exchange anytime before the exercise date (warrant prices would normally track the market price of the share).

Example: Company ABC has issued warrants to its shareholders at a price of Rs 110 per share (current share price is Rs 100). Margin payable is 10 per cent. Warrants are to be exercised 12 months later.

Twelve months later if the price of the share has moved to Rs 150, the warrant holder will exercise the warrant and make a profit of Rs 40 (Rs 150 – Rs 110). In case the price of the share drops to Rs 80, he will not exercise his warrant and allow the margin to be forfeited thereby restricting his loss to Rs 10 per share (margin paid). Now instead of buying the warrant, if he had bought the share at Rs 100, not only would his loss have risen to Rs 20 (Rs 100 – Rs 80) but he would have also blocked the full amount of Rs 100 for 12 months (as against margin of Rs 10 for 12 months).

Remember that the warrant holder does not enjoy the same rights as an equity shareholder, such as voting rights, the right to receive dividend, etc. until the warrant is converted into equity.

A swap is an agreement between two parties to exchange their cash flow streams, without liquidating the asset that generates those flows. The best example of a swap is applicable to the case of a floating rate housing loan. If you expect interest rates to go up in the near future, you could swap your floating rate loan for a fixed rate, without having to prepay your loan and take a fresh one. Even corporations with floating rate debt could swap their liabilities to a fixed rate obligation, without having to retire and reissue debt.

Swaps can be used either for hedging or for speculation, as the party to the contract who does not wish to bear the risk of an uncertain cash flow position swaps it with one who is able to take on this risk, in anticipation of returns. Currency and interest rates are popular underlyings for swaps.