Types of Derivative
A derivativeDerivativeDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. is a kind of financial instrument whose payoff structure is derived from the value of the underlying assets. It is also considered as a product whose value is decided upon the factors known as underlying assets. These underlying assets can be equity, commodity, or Forex. Derivatives are considered as the most effective financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes..
There are primarily three types of derivatives – Forward contractForward ContractForward contracts and future contracts are very similar. Still, the key distinction is that futures contracts are standardized contracts traded on a regulated exchange, whereas forward contracts are OTC contracts, which stand for "over the counter.", Futures Contract, and OptionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.. Prominent financial derivatives types include forwards, options, swaps, and futures contracts.
- Derivatives come in various types, including futures contracts, options contracts, swaps, and forward contracts.
- Each derivative type has unique characteristics, uses, and risk profiles.
- Derivatives allow investors to manage risk, speculate on price movements, and gain exposure to different asset classes.
- Understanding each derivative type’s specific features and mechanics is essential for making informed investment decisions.
Derivatives Types Explained
Types of derivatives are financial contracts, drafted and agreed upon between two or more entities. The value is derived from the underlying asset of the contract or its benchmark. In the modern day, this section of investment is not limited to equity derivatives types. There are derivatives based on the weather as well. As in, the number of days there will be rain or sunshine according to the forecast decide the factors of the derivative contract.
A derivative market is a market for financial instruments. There are different players in the derivatives marketThe Derivatives MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.. Hedgers want to hedge themselves against price risk. A speculatorSpeculatorA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return. wants to make profits from fluctuation while an arbitrager looks for an opportunity that arises out of the product being priced differently in the two markets, namely the spot market and derivative market.
These financial instruments can be used for risk management, leveraging a position, and speculation. The rising popularity of this among investors and traders is due to its ability to fit any need and entities with different risk tolerances.
Top 3 Types
Let us understand each of the financial derivative types in detail through the discussion below.
A forward contract is a type of hedging mechanism where there are two parties involved. It is an agreement that is done on the spot between them regarding buying and selling an asset, but the action is required to be made in the future. Now, one party will buy, and the other party will sell irrespective of the current market price and the condition of the stock market on a specific future date. The other party will be bound to buy the asset if it is not profitable to do so since they are bound by the contract, and the second party will be riskless in his entire transaction. This is a mechanism to hedge the risk to a certain level.
A futures contract is also a risk minimization mechanism. It is quite similar to forwarding contracts, but the only difference is that the futures contract can easily be transferred, and there is a guarantee of performance. The forward contracts are not liquid. Suppose after 15 days of your decision to buy, and you finally decide to backtrack. Now, you want to get rid of the obligation to buy because of the market conditions. Therefore, here if the contract is a futures contract, then this conversion is possible. The buyer can now enter into a second contract, and he can shift his obligation to others.
An option is considered as a contract where there is no liability. The return from the option depends upon the occurrence or non-occurrence of certain events in the stock market. Therefore, it is also considered as a contingent. Basically, in options, the holder of an option is given a right to either buy an asset or sell without any obligation. If the holder of the option opts to buy an asset, it is called a call option, and if he wants to sell, then it is known as a put option. The price at which this is exercised is called the exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. or strike price.
Let us understand the concept of equity derivative types and other related types with the help of an example with a detailed analysis.
A company has surplus cash available in its treasury, which they are going to use for investment. The company now expects to earn a return of 20% on the investment. The experts of the company spotted a bargain in Infosys, currently quoting at $350, but the experts of the company believed that the rise would be to $385 within the next six months. Now they want to make this deal risk-free. Therefore, by choosing a derivative type, the company can shed some risk of uncertainty.
Suppose today (1st January) I enter into a contract to buy dollars @INR 62 on the specified future date (say 1st July) irrespective of what the actual price is on 1st July, you would have done a favor to your company. For example, if the dollar quotes INR 63 on 1st July, you would have gained INR 1 (63-62). If instead, the dollar quotes INR 61, you would have lost INR 1 (62-61). Win or lose, in either case, you would have bought peace of mind by fixing a price.
In a forward contract, there is a risk of default. In a futures contract, there is a guarantee. For example, if anyone wants to buy a futures contract of a rice company and they have now bought 1,000 kg of rice from a seller at that price, which they will pay in future contracts, this is a future contract. The risk is guaranteed to be minimized to a certain level.
Suppose there is a call option with an exercise price of $ 200, the market price is also $ 200 on the same day. One contract equals 100 shares. The stock price increases from $200 to $250; this puts the option holder in a fix. Therefore, the holder must place $50/ share, or $ 5000 in this case with the clearinghouse. The carrying price of the option is now $ 250. On the second day, the price moves to $280, putting the option holder at more risk. The option holder will now have to bring in $ 30 (280-250) per share as an additional margin, and the carrying price moves to $280. This is the mechanism of option derivatives.
Let us understand the limitations of financial derivative types through the explanation below. This discussion will give us a complete overview of the concept as we shall understand the factors from the other end of the spectrum as well.
- Forward Contract: There is no standardization in the forward contract. The price is negotiated between the buyer and the seller; therefore, it is less liquid. There are no margins in the forward contract. There is no guarantee of performance.
- Future Contract: As it depends upon future events to occur, the limitation is that the contract is not independent. The effective reduction in prices of the commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units. hinders the advantage of the futures contracts.
- Options: In options, the commission rate is comparatively higher. Options are also very complicated to understand by ordinary people. The one who is opting for the option has to have knowledge of the subject. Options are not available widely. The options are not available on many stocks.
Frequently Asked Questions ( FAQs)
: futures and forward contracts?
Futures contracts are standardized agreements traded on exchanges, while forward contracts are customized agreements sold in the over-the-counter (OTC) market. Futures contracts have standardized terms, including contract size, expiration dates, and clearinghouse guarantees, whereas forward contracts are tailor-made between two parties.
Options contracts give the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a predetermined price within a specified period. In contrast, futures and forward contracts obligate both parties to buy or sell the underlying asset at a specific price and date.
Swaps are used for various purposes, such as managing interest rate risk (interest rate swaps), hedging currency exposure (currency swaps), or exchanging cash flows based on different financial variables (e.g., commodity swaps or equity swaps). Swaps allow parties to customize the terms of the agreement to suit their specific needs.
Yes, each derivative type has its own set of risks. For example, futures and options contracts are volatile, while swaps may involve counterparty risk. It’s essential to carefully assess and manage the risks associated with each derivative type before engaging in trading or investing activities.
This has been a guide to Derivatives Types. Here we explain the Top 3 types of Derivatives along with their limitations, and examples. You can learn more about financing from the following articles –