Derivatives
Contracts whose value is derived from something else: an asset, a rate or an index. The four families are forwards, futures, swaps and options. They exist so a specific risk can be moved from somebody who does not want it to somebody who will take it for a price, and they differ mainly in who is obliged to do what.
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Why Derivatives matters in interviews
The question is almost never "name four derivatives". It is whether a candidate can say what a derivative is FOR, which is the transfer of a specific risk from somebody who does not want it to somebody who will take it for a price. Everything a markets, structuring or treasury interview asks next depends on that sentence: who is obliged to do what, what the position costs on day one, and where the risk goes if the other side fails.
How it works in practice
Four families cover almost everything, and they differ in who is obliged. A forward commits both sides to transact at an agreed price on an agreed date, bilaterally and on bespoke terms. A future is the same commitment in standardised, exchange-traded form, revalued daily with margin passing between the two sides. A swap exchanges two agreed sets of cash flows, most commonly a fixed rate against a floating one. An option is the odd family out, because only there does one side hold a right and the other an obligation, which is why it is the only one with a premium paid up front.
A worked case makes the symmetry visible. A UK exporter expects $10m in six months. At a spot rate of 1.25 that is £8.00m, but the rate in six months is unknown. Selling the dollars forward at 1.26 fixes the receipt at £7.94m. If the rate moves to 1.35, the unhedged receipt would have been £7.41m, so the forward was worth £0.53m. If it moves to 1.15, the unhedged receipt would have been £8.70m, so the forward cost £0.76m. The hedge did not make the exporter richer on average. It replaced a range of outcomes with one number, and it gave up the good end to do it.
That is the distinction candidates most often miss. A forward, a future and a swap are symmetric: no money changes hands at inception, and both sides can end up on either side of the trade. An option is asymmetric, and the premium is the price of that asymmetry. If an interviewer asks why anyone would pay for an option when a forward is free, the answer is that the forward is only free because it takes the upside away too.
Notional is not exposure, and confusing the two produces the headline numbers that alarm people who do not trade. A $100m interest rate swap does not put $100m at risk; what is at risk is the change in the value of the two cash flow streams, which is a small fraction of it. Risk functions therefore watch gross market value and net credit exposure after collateral, not gross notional outstanding. The same arithmetic is where leverage comes from: a position controlling a large notional for a small initial margin moves far more than the cash posted against it.
Where the counterparty risk sits depends on how the trade is done. An exchange-traded or centrally cleared derivative substitutes the clearing house for the original counterparty and collects variation margin daily, so an unpaid loss is caught within a day rather than at maturity. A bilateral trade leaves the risk with the counterparty, managed by a collateral agreement and by netting. That difference is why the same economic exposure carries a different credit charge on a bank’s books depending on where it was executed.
What candidates get wrong
- Treating notional as the amount at risk. The exposure is the change in value of the contract, not the face amount it references.
- Calling derivatives inherently risky. A contract transfers a risk; whether it adds or removes risk depends entirely on what the holder already owns. The same forward is a hedge for the exporter and a position for the bank on the other side.
- Using future and forward interchangeably. Standardisation, exchange listing and daily margin are the differences, and daily margin is the one with cash flow consequences before maturity.
- Assuming every derivative has an option-shaped payoff. Only options do. A forward or a swap is symmetric, which is why neither costs anything at inception and an option costs a premium.
Derivatives: frequently asked questions
What are derivatives in simple terms?
Contracts whose value is derived from something else: an asset, a rate, an index or another contract. They exist so that a risk can be moved from somebody who does not want it to somebody who will take it for a price. The four common families are forwards, futures, swaps and options, and they differ mainly in who is obliged to do what.
What is the difference between a future and a forward?
Economically they are the same commitment: both sides agree now to transact at a set price on a set date. A forward is bilateral and bespoke, settled at maturity, with the credit risk sitting between the two parties. A future is standardised and exchange-traded, revalued daily with margin passing between the two sides through a clearing house, so gains and losses arrive as cash before maturity rather than at it.
Why would a company use a derivative rather than simply trading the asset?
Three reasons that come up repeatedly. The risk may not be tradeable on its own, as with the currency exposure inside a future receivable. The cash may not be available, because a derivative needs margin rather than the full value of the position. And the view may be about something other than direction, such as how much a price moves rather than which way it goes, which no position in the asset itself can express.
Practise it
The four single-leg option positions at expiry, drawn as two lines rather than one: what the contract settles for, and what it settles for after the premium. Move the strike, the premium or the share price and watch breakeven, maximum gain and maximum loss follow.
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