Types of Derivative
A derivative 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 instruments. There are primarily three types of derivatives – Forward contract, Futures Contract, and Options.
Let us discuss each one of them in detail.
Top 3 Types of Derivatives Product
Let us discuss each type of derivatives product in detail –
Type #1 – Forward Contract
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.
Type #2 – Future Contract
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.
Type #3 – Options
An option is considered as a contract where there is no liability. The return from option depends upon the occurrence or nonoccurrence 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 price or strike price.
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Examples of Derivatives Types
A company has surplus cash available in their 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 dollar @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, and 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 he has 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 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. He is therefore required to 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 derivative.
Limitations of Derivatives
The following are the limitations of derivatives.
- 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 commodity 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.
A derivative market is a market for financial instruments. There are different players in the derivatives market. Hedgers want to hedge themselves against price risk. A speculator 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.
This has been a guide to derivatives types. Here we discuss the Top 3 types of derivatives, including forwarding Contract, Future Contract, Options, along with its limitations. You can learn more about financing from the following articles –