What are Derivatives and Types of Derivatives?

Derivatives are a kind of financial instruments, which obtain their values from other assets. If you want to buy a derivatives contract, the number of derivatives available in the market will flabbergast you. You will be completely spoilt for choices in the derivatives market, but at the same time, you will be confused too. However, the fact is these derivatives are variations of four main types of derivatives. There are four main kinds of derivatives primarily available in the markets, which include forwards, futures, options, and swaps.

Below is a detailed explanation that will help you to understand the major types of derivatives that are available in the Indian share market:

• Forward

Forward contracts are the oldest and the most basic kind of derivatives contract available in the market. As the name suggests, a forward contract is an agreement to buy or sell an asset in the future; the price of the transaction is also decided in the present. The stock exchange is not a party to the contract as it is an agreement between two private parties. Since a forward contract is a customized contract between two parties, there is a higher risk of counterparty credit default risk. The terms of the contract may also vary across contracts. Since the stock exchange is not involved in this, the forward contract is traded over-the-counter. Earlier, finding an interested party was also tough, however, in today’s digital age, this problem has been resolved.

The assets traded as a part of a forward contract are commodities such as pulses, grains, oil, electricity, natural gas, and precious metals. Apart from this, global currencies and financial instruments are also a part of the forward market.

• Futures

A futures contract has many similarities to a forward contract. The similarity lies in the fact that it also involves the sale of an asset or commodity at a future date; the price of this contract is also pre-decided. However, there are many differences between the two.

A futures contract is a standardized contract listed on the exchange. Since the exchange is a party to the futures contract, the terms of the contract cannot be modified, and the risk element is limited. In order to further minimize the risk, all the parties are required to maintain the daily margin requirement at all times.

As the futures contract is traded on the exchange, they are mandated to follow a daily settlement process, which means that any profit/loss realized on a contract on a particular day will have to be settled on that very date itself. This is the most effective way to limit the counterparty risk.

The major point of difference between the two is that both the parties do not need to enter into an agreement with each other, but rather with the exchange.

• Options

This is the third most important kind of derivatives contract that is popular amongst the traders. Unlike the forward and futures contracts, there is an obligation between parties to discharge a contract at a future date. Options, on the other hand, gives one of the parties a right to buy/sell the underlying assets but there is no compulsion or obligation. The other party is bound by obligation to carry out the trade. Options can be traded in the exchange-traded markets, as well as, the over-the-counter markets. Since one party has the privilege to make a choice to buy/sell, it has to pay a privilege or premium to the other party.

Options can be of two types: call and put. Call options give the right but not the compulsion to purchase something at a future date, which is pre-decided. On the other hand, the put option allows you the right but not compulsion to sell something at a pre-determined rate.

• Swaps

A swap is a rather complex kind of derivative in the market. As the name suggests, Swap allows the parties to exchange their stream of cash flows. You can say that an uncertain stream of cash flow can be exchanged for a more certain one. Two of the most popular types of Swaps are ‘Interest Rate Swaps’ and ‘Currency Swaps.’ It is a prevalent practice to exchange a fixed rate interest for a floating one. These derivatives are traded between financial institutions and not retail investors. Investment bankers sometimes act as intermediaries to these contracts. Swaps are known to be exposed to a great extent of exchange rate risks.

Conclusion

These are the four main types of derivatives contract that are most widely used. These days, the derivative contracts involve many combinations of these four basic types, which lead to the formation of complex kinds of contracts. Out of all four derivatives contract, Futures & Options are known to be the most effective hedging instruments, as these can be instrumental in speculating future movement of prices and deriving maximum profit out of the situation.

Your broker, apart from guiding you in opening an online trading account, and helping in how to open a demat account, can also give you complete assistance in derivatives trading, provided he has knowledge of the same.

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