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Types of Derivatives

There are four main types of derivatives: forward contracts, future contracts, option contracts, and swap contracts. Forward contracts are customized agreements between two parties to buy or sell an asset at a future date at a predetermined price. Future contracts are standardized exchange-traded agreements with daily margin requirements and settlement. Option contracts provide the right but not obligation to buy or sell an underlying asset. Swap contracts involve exchanging cash flows of interest rates or currencies between two parties according to a formula.

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264 views

Types of Derivatives

There are four main types of derivatives: forward contracts, future contracts, option contracts, and swap contracts. Forward contracts are customized agreements between two parties to buy or sell an asset at a future date at a predetermined price. Future contracts are standardized exchange-traded agreements with daily margin requirements and settlement. Option contracts provide the right but not obligation to buy or sell an underlying asset. Swap contracts involve exchanging cash flows of interest rates or currencies between two parties according to a formula.

Uploaded by

Priyadharshini
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© © All Rights Reserved
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TYPES OF DERIVATIVES

MEANING
Derivatives are financial contracts that derive their value from an underlying asset. The value of
the underlying asset keeps on changing depending on the market conditions. The derivatives can be
traded by predicting the future price movement of the underlying asset.

The derivatives contracts are widely used to speculate and make good returns. These are used for
various purposes like hedging, access to additional assets, etc.
Different Types of Derivatives in India
There are four types of derivatives that can be traded in the Indian stock market. Each type of
derivative differs from the other and has different contract conditions, risk factor, etc. The different
types of derivatives are as follows
• Forward Contracts
• Future Contracts
• Options Contracts
• Swap Contracts

Forward Contracts
when two parties enter into an agreement to buy or sell an underlying asset at a specified date and
at an agreed price in the future, it is termed as a forward contract.

Forward contracts are an agreement between the parties to sell something on a


future date.

 The forward contracts are customized and have high counterparty risk.
Since the contract is customized, the size of the contract depends on
the term of the contract.
 Forward contracts are self-regulated and no collateral is required for
the same. The forward contract's settlement is done on the maturity
date and hence they must be reversed by the expiry period.
Futures Contracts
Just like the forward contract, a futures contract is an agreement to buy or
sell an underlying instrument at a specified price on a future date. In the
futures contract, the buyer and seller are not required to meet each other to
enter into an agreement.

 In fact, the agreement between them is done via exchange. Since there
is a standardized contract in the futures contract, the counterparty risk
is very low. In addition, the clearing house acts as counterparty to the
parties of the contract which further reduces the credit risk.
 Being a standardized contract, its size is fixed and it is regulated by
the stock exchange.
 Since the future contracts are listed on the stock exchange and being
standard in nature, these contracts cannot be modified in any way.
 To put it in simple words, future contracts have pre-decided format,
pre-decided expiry period and pre-decided size. In future contracts,
initial margin is required as collateral and settlement is done on a daily
basis.

Option Contracts
Options contracts are the third type of derivatives contract.

 Options contracts are very different from futures and forwards


contracts as there is no compulsion to discharge the contract on a
certain date.
 Options contracts are those contracts that give the right but not the
obligation to buy or sell an underlying asset.

There are two types of options:

 Call and put


 The buyer has the right to buy an underlying asset at a price
determined while entering the contract.
 While in the put option, the buyer has the right but not the obligation
to sell an underlying asset at a price determined while entering the
contract. In both the contracts the buyer has the option to settle the
contracts on or before the expiry period.
 Therefore anyone trading in the options contract has the option of
taking any of the 4 positions i.e. long or short in either the put option
or the call option. Options are traded at over the counter market and at
the stock exchange.

Swap Contracts
Out of the various types of derivatives contracts, swap contracts are the most
complicated. Swap contracts are private agreements between two parties.

 The parties to the contract agree to exchange their cash flow in the
future as per a predetermined formula.
 The underlying security under swap contracts is interest rate or
currency. Since both interest rate and currency are volatile in nature, it
makes swap contracts risky.
 Swap contracts protect the parties from various risks. These contracts
are not traded on the exchanges and investment bankers are the
middlemen to these contracts.

 To conclude,derivatives contracts like forwards, futures and options


are one of the best hedging instruments. The traders can predict future
price movements and make good profits out of them.
For further assistance regarding derivatives contracts trading, you can
contact India Nivesh who can assist you with trading in derivatives.

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