If you are a regular to our blogs, you might have read briefly about types of derivatives in our previous blog, What is Derivative in stock market. Continuing the same, this article explains about types of derivatives in detail. But before we start, let’s have a quick recap of what you learned in the previous article.
A derivative is a financial contract. Derivatives are also called financial derivatives. They derive their value from some other asset. Such assets from whom a derivative derives its value are known as underlying assets or simply underlying.
The real topic starts from this point, so keep reading.
- What is a Derivative?
- Types of Financial Derivatives
- Future Derivatives
- Forward Contract
- Options Contract
- Swap Derivatives
- Quick Summary
What is a Derivative?
Simply put, the meaning of derivative is when a financial contract derives its value from some other underlying asset, we can call it a derivative. As the price of the underlying asset changes, the price of the derivative fluctuates.
A derivate contract is set between two or more parties and is traded on an exchange or over-the-counter. Some of the common types of financial derivatives are futures contracts, forwards, options, and swaps. Traders use derivatives to explore different markets and trade different assets. The most common underlying assets for derivatives are stocks, commodities, currencies, and market indexes.
Types of Financial Derivatives
Derivatives are good instruments to operate in the stock market. Once traders get hang of them, they can take positions and make handsome profits. There are several types of financial derivatives. Let’s look at some of them with examples.
A futures contract is a legally binding agreement between two parties to buy or sell an underlying asset at a set price on a future date, which is also called the expiry date. A futures contract is executed directly through a regulated stock exchange. Futures derivatives are generally used to speculate in the commodity and equity markets.
Some different types of futures contracts are:
Stock Futures: Stock futures are less than 20 years old in India. Trading in stock futures gives traders leverage. Futures are only available on a selected list of stocks.
Index Futures: Index futures can be used to speculate on the movements of indices, like the Sensex or Nifty, in the future.
Currency Futures: A currency futures contract allows traders to buy or sell a currency at a specific rate against another currency at a fixed date in the future.
Commodity Futures: Commodity futures allow traders to hedge against price changes in the future of various commodities, including agricultural products, gold, silver, petroleum, etc.
Interest rate futures: It’s a contract for traders to buy or sell a debt instrument at a fixed price on a fixed date. The assets are government bonds or treasury bills. Traders can trade these on NSE and BSE.
Forward contracts are similar to futures contracts. However, forwards are not traded through a regulated stock market; hence they are traded over-the-counter. This type of derivative is used for hedging. As they are over-the-counter (OTC) contracts, they do carry more risk for both parties involved. Forwards have counterparty risk. It is a kind of credit risk where the buyer or seller may not be able to keep their part of the obligation. Therefore, if the buyer or seller becomes insolvent, the other party may not have a way to save their position.
Some different types of forward contracts are:
Window Forwards: These contracts are based on the same logic as forwards. A defined amount is insured by a fixed exchange rate, with the only exception being that the settlement date is variable.
Long-Dated Forwards: Here, the settlement date is longer than one year and as far away as 10 years. Generally, most firms use long-dated forward contracts to hedge ongoing risks like currency or interest rate exposures.
Non-Deliverable Forwards (NDFs): An NDF is a cash-settled, short-term forward contract. It is so named because the notional amount is never exchanged.
Flexible Forward: Also known as an open forward contract, a flexible forward is a contractual agreement to buy or sell a specified amount of one type of currency against the payment in another type of currency on or before the set date in the future known as the value date.
Options are contracts that give the buyer the right to sell or buy an asset at a certain price on the expiration date of the contract or before that. The crucial thing here is that the buyer is under no obligation to trade the security. If the buyer does trade, then it is called exercising the option.
Some different types of options contracts are:
Call option: It is a facility that gives the trader the right but not an obligation to buy a security or an asset on or before the expiration of the contract at a fixed price.
Put option: It is a facility that gives the trader the right but not an obligation to sell a security or an asset on or before the expiration of the contract at a fixed price.
Stock Options: It has the shares of the listed company as its underlying asset.
Index Options: It tracks indices like Nifty and Sensex.
Swap means to give something for something else or to make an exchange. When two parties agree to exchange their liabilities or cash flows from separate underlying assets held by them in order to hedge their risks, then it is known as a swap contract.
Some different types of swap contracts are
Interest Rate Swaps: The objective behind this kind of swap is to shift the cash flow coming from a fixed rate of interest to a floating rate of interest and vice versa so that risk with respect to the interest rate can be hedged or speculation can be done.
Currency Swaps: When two parties from different countries agree to exchange the cash flows in two currencies, then it is called a currency swap.
Commodity swap: In a commodity swap exchange of cash flows is based upon the price of a commodity.
- Financial derivatives derive their value from some other asset. Assets from which a derivative derives its value are known as underlying assets.
- There are several types of derivatives: Future Derivatives, Forward Contract, Options Contract, and Swap Derivatives.
- A futures contract is a legally binding agreement between two parties to buy or sell an underlying asset at a set price on a future date.
- Forward contracts are similar to futures contracts. However, forwards are not traded through a regulated stock market; hence they are traded over-the-counter.
- Options are contracts that give the buyer the right to sell or buy an asset at a certain price on the expiration date of the contract or before that.
- When two parties agree to exchange their liabilities or cash flows from separate underlying assets held by them in order to hedge their risks, then it is known as a swap contract.