Types of Derivatives

More on Derivatives

When traders look to enter into the derivatives segment, they often miss out on the basics such as even understanding that there are multiple types of derivatives. Don’t you think, aspects like these must not be overlooked!

In this quick review, let’s talk about this but before that, we will talk about the basics of derivatives trading!

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 Types of Derivatives have been introduced that help investors to manage their risks and to guarantee their returns to as much extent as possible.

One such instrument is Derivatives.

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 Market

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:

Forward Contracts:

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.

Future Contracts:

A futures 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 futures 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 a price less than the market price and make profits.

Options Contracts:

Options are one of the most widely used types of derivatives. Furthermore, there are multiple types of options.

Option Trading is 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 a 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.

Swap Contracts:

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.

This is one of the types of currency derivatives. Like other trading segments, the currency segment also has multiple derivative contract types such as Currency Futures Contract, Currency Forward Contracts, Currency Options contract and of course the one in this context i.e. Currency Swap Contract.

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 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.

Types of Derivative Instruments

There is no difference between the types of derivatives and derivative instruments and both of these terms can be used interchangeably.

In other words, the different types of derivative instruments i.e. forward contracts, futures contracts, swap contracts, options contracts.

So, if you read anywhere about the types of derivatives or derivative instruments, you can assume it to be the same term.

Types of Derivative With Examples

Now, let’s take a few examples to understand the above-mentioned concepts.

We will start with the Forward Contracts:

Let’s say Parag Shirts is looking to complete an order of 10,000 shirts in the next 3 months.

In order to complete this order, they are looking for cotton raw material and have now finalized Sundram Mills as the cotton vendor. Currently, cotton is being traded at ₹300 per quintal.

At the same time, the monsoon is knocking the doors soon and if the rainfall happens beyond the expectations, the major chunk of Sundram mills crop might get destroyed.

In such a case, the supply of cotton will go down, thereby increasing the price of per quintal cotton.

Similarly, there is a possibility that the price of cotton may fall down as well if the rain falls as per the optimal expectations and the supply increases.

Both the parties get into a contract where they finalize the price of the cotton at ₹300 per quintal on a specific date after 3 months. Now, irrespective of fact that the price sees a fall or a jump, the price of a quintal has been finalized and both parties will need to take care of that at the expiry date.

Depending on the direction the price moves, the corresponding profit and loss can be calculated for the requisite party.

One of the most important points that need to be remembered for a forward contract is that it happens over the counter or OTC.

Now, let’s move ahead and take an example of the one another Types of Derivatives i.e. futures contract:

This type of contract is different from the forward contract in the sense that in this case, trading happens through a regulated stock market exchange.

Thus, if you take the above-mentioned example and consider the point that whatever price movements happen, they are put at the index and the corresponding actions are taken by the parties involved.

In simpler terms, if the current market price of 1 quintal cotton is ₹300 on the index, with higher rains, this price can go high (₹500 let’s say) since the supply will go down.

Now, it makes complete sense for Parag shirts to go ahead and exercise their contract. Similarly, the price of each quintal can go down as well if rain is optimal this season.

Moving forward, if we take the example of an options contract, then this needs to be known that terms such as strike price, premium carry major importance in determining the profit and loss to either party at the expiry date.

Also, within options, you have types such as a call option and a put option which work in their own separate ways.

To keep it simple, let’s pick one of these types and take an example. Let’s say you go for a call option and are bullish towards a particular stock which is currently trading at ₹120.

You get into an options contract with a seller at a strike price of ₹125 by paying a premium amount of ₹20.

In an options contract, you buy/sell 100 shares in a lot. Thus, the amount you pay is ₹20 X 100 i.e. ₹2000 as the overall premium. Now, to be profitable from here, the stock price at the expiry date must exceed by such a number that even after deducting ₹2000, you stay profitable.

Otherwise, it won’t sense for you to exercise this call option. Right?

Imagine that the stock price reached a price point of ₹160. Now, here the overall potential profit will be calculated as:

= ₹(160 – 125) X 100

= ₹3500

Now, after deducting ₹2000 premium amount from this ₹3500, you will receive an overall profit of ₹1500 from this contract.

Lastly, there are swap contracts, other interesting Types of Derivatives.

These type of contracts generally happen between larger organizations in order to safeguard themselves towards currency or interest rate risks.

A quick example can be, let’s say, the same Parag Shirts company wants to export its shirts to the US market. It takes a loan for this venture from an Indian bank which will charge an interest amount from this company.

Now, Parag shirts is making its revenue in USD while paying interest in INR.

Thus, here the currency pair exchange rate will also play a major role in figuring out the gross and net profit made by the shirts company. Thus, Parag Shirts can get into a swap contract with a US-based company that is looking to sell its products to the Indian market.

Both parties will look to safeguard themselves with opposite viewpoints towards the market direction. With this, the swap contract can be arranged.

Well, this is pretty much what we wanted to cover in this review on Types of derivatives.

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