Forwards, Swaps and Futures

Most investors have an understanding on how traditional markets work. Most known the difference between equities, bonds, property,
and money market funds. For instance if you have equity in a company like Microsoft and that companies share price falls, so does the value of your holding. Conversely if the share price rises you're a winner. Increasing awareness of uncertainty in the economic environment has changed the way financial markets operate.
Successful strategies require that the risks inherent in changes in interest rates, currencies and commodities be successfully managed
Firms have turned to a number of different instruments to manage these risks. The most common approach is for firms to hedge.
Back in 1949 Alfred W.Jones started an investment company which he called a hedge fund because it would not just buy the stocks it liked,
it would also sell stocks short that it felt were overvalued. Since it was hedged this way the fund was less susceptible to big market moves than traditional funds.
But it was not until 1992 that these funds captured the imagination of large institutional investors, with George Soros's Quantum fund, founded in the 60's now worth billions of dollars. Since the early 90's some firms have been targeting retail investors and undoubtedly these alternative investment funds will become an increasing part of most people's portfolios.
So I will attempt to give investors a simple guide to a complicated area and try to explain the terminology used by brokers, hopefully working on your behalf..
There are two principal kinds of products used to manage financial risk: terminal instruments and options. The terminal products are Forwards, Swaps and Futures All of these, together with options, make up the derivative product set.
Forward Contracts are the simplest to understand. They bind the buyer, or long position holder, to buy a given asset on a set date in the future at a price agreed at the time the contract is entered into. If at the time the contract matures the market price is above the contracted price, the buyer gains. If however the market price is below the contracted price the buyer loses. The opposite applies to the seller or short position holder. A major problem with forward contracts is the default or credit risk. Will both parties honour their obligation?
Futures contracts whether on commodities or exchange rates have the same characteristics as a forward . They were originally conceived as a means of eliminating credit risk from a forward contract.(Achieved by utiliising a clearing house and margin calls).
Suppose the one year interest rate in the US was 10% and 5% in Switzerland. and the exchange rate is 2 SFR to the dollar. I borrow 2 million Swiss Francs at 5% and immediately convert them into US$1 million. I wire the funds to Wall St. and lend at 10% I enter a futures contract to convert back to Swiss Francs in a years time at 10%
After one year I have 1.1 million dollars which equals 2.2 million SFR I repay the 2 million SFR + interest @5% of 100,000 sfr leaving me with a risk free profit (Arbitrage) of SFR 100,000 less trading commissions..
Swaps. The newest of the terminal contracts, sometimes called an exchange contract, obliges the two parties to exchange or swap a series of cash flows at specified intervals over a particular time period.
An extreme example to illustrate the use of an intrest rate swap.
Lets say BMW can borrow I billion Euro in Frankfurt at 5% but in New York has to pay 10% for US$ 1 billion
IBM can borrow US$ 1 billion at 5% in New York but 1 billion Euro in Frankfurt would cost them 10%. Let's say 1 dollar = 1 euro
A merchant bank would bring both parties together and arrange a swap contract. The effect would be to transform a euro loan into a dollar one and vice versa
Both companies have avoided a penal 10% interest rate which they would have to pay on the market if they wished to borrow and expand abroad.