17.14 Other derivatives instruments
We have discussed three most common derivative instruments so far. There are other instruments and few of them are briefly covered here.
Swaps:
These are the most complex derivatives because they are often combinations of all the other derivatives and assets we have mentioned. On top of that, they have two sides to them. Something is given, something is taken. In market lingo spreads, switches, rollovers, repos, and swaps all mean two-sided trades. An exchange of one asset for another. You give something and you get something else in return. You might buy gold for delivery in London tomorrow and simultaneously sell gold for Indian delivery next week. Or buy a T-bill for delivery tomorrow and sell a 2-year T-note for delivery tomorrow also. The assets can vary, the dates can vary, and so on. But something is bought and a different thing is sold. Swaps are derivatives involving exchange of cash flows over time, typically between two parties. One party makes a payment to the other depending upon whether a price is above or below a reference price specified in the swap contract. They can be regarded as portfolios of forward contracts.
The two commonly used swaps are:
- Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
- Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.