Financial markets are extremely volatile. Prices of the securities like equity, currency, interest rate, commodities keep on going up and down affected by various internal and external factors. Due to the factor of volatility, the financial markets are very risky.
What a trader speculates may not end up holding true in a matter of minutes and the entire capital may get washed away. The trend that the investor predicted may not hold up and the profits may no longer stay.
Therefore, the primary concern of a trader or investor is to manage his risks, along with maintaining his returns. Due to the risk elements inherent in the financial markets, various instruments have been introduced that help investors to manage their risks and to guarantee their returns to as much extent as possible.
Derivatives are the financial contracts that derive their value from the underlying assets. The underlying assets, in this case, can be stocks, commodities, indices, currencies, rate of interest or exchange rates.
The value of a derivative depends on the value of its underlying asset, thus by predicting the future price of the asset, the future price of the derivative contract can be judged and traded on.
Derivatives are one of the most complex financial instruments, and the most rewarding ones too. Derivatives are very beneficial for hedging, arbitrage and to obtain leverage.
Types of Derivatives
There are various types of derivatives available to choose from. The types of derivatives differ in the conditions of the contract, objectives and risk and return pattern. There are many sub-categories of derivatives but the main four types of derivatives are:
A forward contract is one of the simplest and oldest types of derivatives. It is an agreement between two parties, buyer and seller, to buy or sell an asset at a future date at a price that is decided upon today. They are also called forward commitments and they do not give the right of cancellation to either of the parties.
The drawback is that the forward contract is only between the two parties and the exchange does not act as an intermediary, so there is a high risk of default. The contract is, truly and literally, of a private nature between the buyer and the seller and there is no obligation to release the information of the transaction publicly.
The forward contract can also be customised according to the needs of the involved parties and does not have to follow a standardised format. For example, party A holds a real-estate property that it intends to sell in one year and party B intends to buy the property in a year, so they both enter into a customised forward contract, deciding the delivery date and the price of the asset today.
A future contract is one of the types of derivatives which evolved out of the forward contracts. Futures contract involves a legal agreement to buy or sell a derivative at a predetermined price at a predetermined time in the future.
The underlying asset of the derivative can be a commodity or a financial instrument.
A very important point to be considered is that in futures trading, the buyer and seller have an obligation to fulfil the contract at the predetermined price and time. The predetermined price is called the futures price and the predetermined time is called the delivery date.
It is safer than the forwards as it trades on the exchange and with an intermediary, it becomes safer and less prone to defaults. Due to the involvement of exchange, the future contracts are standardised and they cannot be customised according to the needs of the specific buyers and sellers.
Furthermore, future contracts are subject to daily settlement, unlike the forward contracts.
For example, a trader anticipates that the share price of IBM is about to go up in the near future, he buys the stock futures of IBM at the underlying price. Now, by the expiry date, if the price of IBM shares goes up, he can now buy the IBM shares at price less than the market price and make profits.
Options are one of the most widely used types of derivatives. Option Tradingis a form of contract in which the buyer of the option has the right to exercise his option at a specified price within a specified period of time. It is to be noted here that in options trading, the buyer does not have the obligation to exercise the option.
He may or not exercise the option to buy or sell a security, depending on the market price of the security. A fee or premium is charged for entering into an options contract. Options are also traded on the exchange and are standardised. Options are of two types: Call and Put.
A call option gives the buyer the right to buy an underlying asset at a predetermined price at or before the expiry, whereas put option gives the buyer the right and not the obligation to sell an underlying asset at a predetermined price at or before the expiry.
Swaps are one of the most complicated types of derivatives. A swap contract is a private agreement between two parties to exchange their cash flows in the future according to a formula that is predetermined. Since the swaps are private agreements, they carry huge amounts of risks.
They are also risky because the underlying security in most swaps is currency or interest rate which are very volatile. The two most common types of swaps are interest rate swaps and currency swaps.
In interest rate swaps, there is swapping of only interest related cash flows between the parties, in the same currency, but in currency swaps, both principal and interest related cash flows are swapped and the currency of cash flows in one direction is different from the currency of the cash flow in the other direction.
Thus, multiple instruments are available for the investors to trade in the derivatives market. They differ in the basic conditions and how they work for either of the parties, but the purpose of all types of derivatives remains to hedge the risks of the investors and help them in retaining profits.
With this, we sum up this detailed review of different types of derivatives. This needs to be understood that each of these types has their own sets of pros and cons and a trader need to take an objective and a wise call before using any of these types.
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