Sorting trades by settlement date
Every transaction has a trade date, when the deal is struck, and a settlement date, when payment and delivery happen. The gap between them gives the first three names.
The digit after T is the number of days between trade and settlement. Cash is T+0, tom is T+1, spot is conventionally T+2. A question that describes settlement the next day is describing a tom trade even if it uses the word spot loosely elsewhere.
Forwards: a private promise
A forward contract is an agreement between two parties to buy or sell an underlying asset on a certain future date at a price decided when the contract is made. Both parties are committed and must honour the deal whatever the asset's price turns out to be at settlement. Because the terms are negotiated privately, they are customised, and the contract is over the counter.
A cotton grower agrees in June to sell her October harvest to a textile mill at a price both accept today. Quantity, quality, price, payment terms and whether the deal is settled in cash against a benchmark or by physical delivery are all written by the two of them. If cotton prices double by October, the grower still delivers at the June price. If they halve, the mill still pays it.
The weakness is counterparty risk: either side may fail to perform. Forwards are therefore usually made between parties who know each other and rely on informal protection to see the contract honoured. The syllabus observes that commodity forward markets in parts of India run on mutual trust and function despite the risk.
Futures: the forward, standardised
A futures contract is a forward that trades on an exchange. Standardisation replaces negotiation: market lots (traded quantities), quality, delivery date, and whether settlement is in cash or by physical delivery are all fixed by the exchange. Because trades are executed and settled on the exchange and the clearing corporation guarantees settlement, the clearing corporation imposes strict margins. Futures exist on equities, equity indices, commodities, currencies and interest rates.
A commodity futures contract specification reads like a rulebook: the trading unit in tonnes, the minimum order size, the maximum position an individual may hold, the quality standard the exchange accepts, the dates on which the contract begins and delivers, whether delivery is physical only, and which exchange-approved warehouses may deliver.
| Forward | Futures | |
|---|---|---|
| Where | Over the counter | Exchange |
| Terms | Customised by the two parties | Standardised by the exchange |
| Counterparty risk | Borne by the parties | Taken on by the clearing corporation |
| Margins | None required | Stringent |
Options: a right on one side, an obligation on the other
An option is a contract that gives the right, but not the obligation, to buy or sell the underlying asset on or before a stated date at a stated price. The buyer, or holder, pays a premium and receives the right. The writer, or seller, receives the premium and carries the obligation to sell or buy if the holder exercises. A call gives the right to buy a given quantity at a given price on or before a given date; a put gives the right to sell. Options trade both over the counter and on exchanges.
Strike price (or exercise price): the price at which the holder may buy or sell. Premium: the upfront payment from buyer to writer, the price of the option. Settlement date: when the contract completes. In the money: exercising would pay; out of the money: exercising would not, so the option expires worthless.
Meena buys a call on a share from Arjun with a strike of 500, expiring in three months, and pays a premium of 20. If the share is at 560 at expiry, the option is in the money: Meena buys at 500 what is worth 560, gaining 60 gross and 40 net after the premium. Arjun keeps the 20 premium but must sell at 500 a share worth 560, so his net result is minus 40, the mirror image. If the share is at 470, there is no point paying 500 for it; the option is out of the money and expires worthless. Meena loses her 20, Arjun keeps it, and that 20 is the most a writer can ever make. Meena breaks even at 520, the strike plus the premium.
The buyer's worst case is the premium. The writer's best case is the premium. For a call writer, losses grow without limit as the price rises; the exam's put-writer and put-buyer questions follow the same logic in the other direction, with the buyer of a put gaining as the price falls below the strike minus the premium.
Swaps: exchanging cash flows
A swap is a derivative contract between two parties to exchange cash flows in the future according to a pre-arranged formula. Swaps help participants manage volatile interest rates, currency rates and commodity prices.
A borrower's loan charges quarterly interest at the Treasury bill rate plus a spread, so his obligation floats with each quarter's rate. He prefers certainty. In the swap market he agrees to pay a fixed rate to a swap dealer every quarter and to receive the Treasury bill rate plus spread from the dealer every quarter. The floating amount he receives pays the floating interest on his loan; the two floating legs cancel; what remains is a fixed payment. Interest is calculated on an agreed principal called the notional, and only the interest is exchanged, never the notional itself.
- Cash trades settle on the trade day (T+0), tom trades the next day (T+1), spot trades on the spot date, normally two business days later; Indian equities have moved to T+1.
- A forward is a customised OTC agreement binding both parties to a future trade at a price fixed today, with counterparty risk borne by the parties. A futures contract is a standardised, exchange-traded forward with margins and a clearing corporation guarantee.
- An option gives its buyer a right without obligation; the buyer pays the premium, the writer receives it and carries the obligation if the buyer exercises. A call is the right to buy, a put the right to sell.
- A swap exchanges future cash flows by a pre-arranged formula on a notional principal that never changes hands; a borrower paying floating can convert to fixed by paying fixed and receiving floating.