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Derivative Types Explained
A derivative is a financial instrument whose value is derived from the performance of a security, commodity, or index.Derivatives are used for speculation, risk managеmеnt, and profit gеnеration, this can be found in various markеts such as stocks, bonds, options and futurеs. Thеy allow buyеrs and sеllеrs to еntеr into contracts for future transactions without thе obligation to carry out thе dеal until thе contract expires, thus increasing market liquidity and facilitating еasiеr transactions bеtwееn parties.
Published on 25 June 2024
Howеvеr, somе derivatives can have negative impacts bеyond thе underlying tradе. For instance, thе usе of derivatives by large banks before thе financial crisis rеsultеd in significant lossеs for consumеrs, statе govеrnmеnts and businеssеs worldwide. It's important to be cautious when trading thеsе instrumеnts and fully understand their risks. Lеt's еxaminе thе different types of dеrivativеs.
Brief About Derivative
A financial contract between two or more parties is known as a derivative. Such a contract's value is based on the worth of an asset known as the underlying asset. These types of derivative contracts are called derivatives since the contract's value is effectively derived from the value of the underlying asset.
Price risk, or the possibility that an asset's price would decline in the future, is something that is frequently hedged against with derivatives. We call this process hedging. Alternatively, speculation—using changes in an asset's price to make money—can also be done with derivatives.
What Are The Derivatives Types?
There are four different types of derivatives that can easily be traded in the Indian Stock Market. Each derivative is different from the other and consists of varying contract conditions, risk factor and more.
The four different types of derivatives contract are as follows:
Forward Contract
When two or more parties formally agree to buy or sell an asset at a defined future date for a fixed price, this is known as a forward contract. Forward contracts typically lack conventional conditions and are highly personalized. Additionally, they are not traded on any exchange because the contract is tailored to the needs of the parties involved. Forward contracts are unregulated, in contrast to other derivatives. This is a significant disadvantage since there is always a chance that the counterparty won't uphold their end of the bargain.
You can hedge against future price changes with a forward contract. For instance, you can get into a forward contract with a farmer to safeguard yourself against future price hikes if you're a wholesale trader dealing in wheat. You will benefit financially from price increases, while the farmer may suffer losses. It works the other way around if the price drops.
Future
An agreement between two parties for the purchase and delivery of an item at a certain price at a later period is known as a futures contract, or simply futures. Standardized contracts that are traded on an exchange are called futures. A futures contract is used by traders to speculate on the price of an underlying asset or to hedge their risk. Each of the parties has an obligation to carry out the agreement to purchase or sell the underlying asset.
At $62.22 per barrel, Company A purchases an oil futures contract that expires on December 19, 2021. By doing this, the corporation reduces the danger of a price increase before it needs to buy. Company A may choose to take delivery or sell the contract before it expires for a profit if oil prices increase to $80 per barrel.
Options
In India, options contracts are the third type of derivative markets. Contracts for options are very different from contracts for futures and formats because there is no requirement to fulfill the contract by a certain date.
The right, but not the obligation, to purchase or sell an underlying instrument is provided via options contracts.
Option contracts consist of two options:
- Call Option
- Put Option
The buyer of any option is free to enter the contracts with the full right to buy the underlying asset at a predetermined price. The buyer enters the contract with the full right, but not the duty, to sell an underlying asset at a preset price while using an input option.
Nonetheless, the buyer has the option to settle all of the contracts on or before the expiration date in both call and put option contracts.
As a result, anyone who frequently traded option contracts can adopt one of the four possible positions—that is, short or long—in either the put or call option. These options are traded on the over-the-counter market as well as the stock exchange..
Swap
A swap contract is an agreement between two parties to "swap" the cash flows or income streams that come from their respective assets. Swaps are not traded on an exchange and are thus highly customizable, much like future contracts. They experience counterparty risk as a result.
Entities typically engage in interest rate, currency, and hybrid swaps, which are the three types of swaps. Two parties swap the cash flows from their respective fixed-interest debt instruments in an interest rate swap. Two parties trade cash flows in two distinct currencies during a currency swap. Lastly, two parties exchange cash flows from various instruments and in several currencies in a hybrid swap.
Derivative Contract Example
Typical derivatives include credit default swaps, futures contracts, and option contracts. Other types of derivative contracts exist as well, tailored to the requirements of different counterparties. In fact, because derivatives are often offered over-the-counter (OTC), there are almost endless ways to tailor them.
Wrapping It Up
It may appear that derivatives are complicated financial tools. But once you get the feel of it, understanding it becomes really simple. The only two types of derivatives contracts that are currently available to retail traders like yourself if you want to trade in derivatives are futures and options.
However, in order to trade in these contracts, you must first open a trading account and a demat account. It is an absolute necessity. Simply go to Espresso to quickly open a trading and demat account. Your account can be activated quickly by completing the entire account opening process online.
