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1.2 Types of derivatives
Publication date: 31 Mar 2024
us Derivatives & hedging guide
A derivative is a contract whose value is dependent upon (or derived from) fluctuations in one or more underlyings. For example, the value of an interest rate swap varies with changes in an interest rate index (e.g., the Secured Overnight Financing Rate or “SOFR”). Common underlying assets include investment securities, commodities, currencies, interest rates and other market indices.
There are two broad categories of derivatives: option-based contracts and forward-based contracts.
1.2.1 Option-based derivative contracts
Option-based derivative contracts provide the holder with the option, but not the obligation, to exercise the contract. The party that sells the option may be referred to as the option writer; the party that buys the option is the option holder. Typically, an option holder will exercise its option when it is in the money (i.e., economically worthwhile), but not when it is out of the money. The following are common types of option-based derivatives:
- A call option gives the holder the right, but not the obligation, to buy an asset at a specified price (strike price or exercise price) on or before a maturity date (expiration date). For example, the holder of a call option on crude oil may have the right to purchase 100,000 barrels of a specific grade of crude oil for $62 per barrel within the next three months.
A call option is in the money when the price of the underlying asset is greater than the strike price (exercise price) of the option. - A put option gives the holder the right, but not the obligation, to sell an asset at a specified future price on or before a maturity date. For example, the holder of a put option on an equity security may have the right to sell 700,000 shares of a publicly-traded stock at $100 per share within the next year.
A put option is in the money when the price of the underlying asset is lower than the strike price (exercise price) of the option. - A warrant is a call option written by a reporting entity on its own common or preferred equity shares. It grants the holder the right, but not the obligation, to purchase the underlying shares at a specified price on or before the maturity date. For example, the holder of a warrant may have the right to purchase one thousand shares of the issuer’s common stock for $100 per share within two years.
1.2.2 Forward contracts
Forward derivative contracts require the payment of the agreed-upon forward price in exchange for the underlying asset on or before a maturity date. The following are common types of forward derivatives:
- Swap contracts are instruments that require the counterparties to exchange (or swap) cash flows at specified intervals (e.g., every three months) on or before a maturity date. The underlying cash flows can be based on interest rates, foreign currency exchange rates, or other assets or indices. For example, in an interest rate swap, counterparties will exchange payments based on a specified fixed interest rate and a variable interest rate, such as SOFR.
- Forward contracts are customized instruments to buy or sell an asset at a specified future date at a predetermined price. For example, a reporting entity may agree to purchase 1 million euros one year from now at a fixed price of $1.25 million.
- Futures contracts are standardized instruments to buy or sell an asset at a specified future date at a predetermined price. For example, a reporting entity may enter into a futures contract to purchase 1,000 barrels of a specific grade of crude oil one year from now at a fixed price of $62 per barrel.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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