Derivatives: Definition, Concept and Types

 

What are derivatives?

• A derivative is a contract between two parties, where the contract derives its value/price from an underlying asset.
• The most common types of derivatives are forwards, futures, options, and swaps.
• Underlying assets could include commodities, stocks, bonds, interest rates, and currencies.
• People enter into derivative contracts to earn a huge amount of profits by contemplating the underlying asset’s value in the future.

 

Types of derivatives

Forward

• A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are
• They are bilateral contracts and hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• The contract has to be settled by delivery of the asset on expiration date.
• In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

 

 

Futures

• Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for a future delivery at an agreed price.
• There is an agreement to buy or sell a specified quantity of financial instrument commodity in a designated future month at a price agreed upon by the buyer and seller.
• To make trading possible, BSE specifies certain standardized features of the contract.

 

Difference between forwards and futures

Sr.No	Basis	Futures	Forwards
1	Nature	Traded on organized exchange	Over the Counter
2	Contract Terms	Standardized	Customised
3	Liquidity	More liquid	Less liquid
4	Margin Payments	Requires margin payments	Not required
5	Settlement	Follows daily settlement	At the end of the period.
6	Squaring off	Can be reversed with any member of the Exchange.	Contract can be reversed only with the same counter-party with whom it was entered into.

 

Options

• Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a certain period of time.
• This contract does not require any compulsion to discharge the contract on a specific date, which means the buyer is not under any obligation to exercise the option.
• Options contracts provide the right but not the commitment to buy or sell an underlying instrument.

Swap

• Swap contracts are the most complex contracts, among the four derivatives.
• Swap contracts mean the agreement is done privately between both parties. The parties who of the swap contracts agree to exchange their cash flow in the future as per a pre-determined formula.
• Under these types of contracts, the underlying security is the interest rate or currency, as these contracts protect both parties from several major risks.
• These contracts are not traded to the Stock Exchange as investment banker plays the role of a middleman between these contracts.

 

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