One of my classmate answer to the question:
Discuss and provide examples of at least four derivative securities. Be sure to include the pros and cons of each one.
so please provide proper feedback to his reply considering the question he has answered
Here is his reply:
Four derivative securities are forward contracts, futures contracts, options and swaps.
Forward contracts are "agreements involving the exchange of assets for cash at a fixed price in the future" (Saunders & Cornett, 2008, p. 700). A pro for forward contracts is they are tailor made between buyer and seller, so whatever they agree upon is what they have to look forward to (Saunders & Cornett, 2008). A con for forward contracts is they run the risk of default.
A futures contract is "an agreement involving the future exchange of an asset for cash at a price that is determined daily" (Saunders & Cornett, 2008, p. 701). A pro for futures contracts is they are traded on, and guaranteed by an exchange, so the risk of default is minimal, and a con is the contracts are standardized.
An option is a contract that gives the holder the right but not the obligation to buy or sell the underlying asset at a specified price within a specified period of time" (Saunders & Cornett, 2008, p. 733). A pro for option contracts is the buyer is not obligated, they can just walk away. Some cons are the seller may not be able or willing to perform, depending on the agreement, the buyer loses money if they don't exercise, and the price can be extreme in either direction.
"A swap is an agreement between 2 parties to exchange assets or a series of cash flows for a specific period of time at a specified interval" (Saunders & Cornett, 2008, p.774). A pro for swaps is that it allows a financial institution to hedge against interest rates in the long-term (interest rate swap). A con is that swaps run the risk of default, which puts both parties at risk (Saunders & Cornett, 2008, p. 776).
Tim
Reference
Saunders, A. & Cornett, M. (2008). Financial Institutions Management: A Risk Management
Approach. 7th Edition. McGraw-Hill-Irwin.