- Forwards: a private agreement to buy or sell at a fixed price on a set future date.
- Futures: forwards with standardised terms, traded on an exchange.
- Options: the right without the obligation to buy (a call) or sell (a put) at a strike price, for which the buyer pays a premium.
- Swaps: an exchange of cash flow streams over an agreed term, such as fixed interest payments against floating ones.
The three-part test
IFRS 9 supplies the accounting test, and it doubles as a good mental model: the contract's value moves with its underlying, it needs little or no initial investment compared with buying that underlying directly, and it settles in the future. The second feature is the source of both usefulness and danger, because it is built-in leverage. An airline fixing next year's fuel cost, an exporter locking in an exchange rate and a pension fund matching its liabilities with interest rate swaps are all hedging. A retail trader buying a contract for difference on a share index takes the same kind of exposure for a different purpose, which is why ESMA restricts how those contracts may be sold to retail clients.
After the financial crisis, the G20 committed at its Pittsburgh summit in 2009 to reform over-the-counter derivatives markets: trade reporting, central clearing of standardised contracts, trading on exchanges or electronic platforms where appropriate, and higher capital and margin for contracts left uncleared. The ECB has published its own review of how far those reforms went. Pricing any derivative combines discounting, using the time value of money, with a model of how the underlying may move, and the field is mapped in trading and derivatives. Used carelessly, a derivative can concentrate the very risk that diversification was meant to spread.