.png)
Financial Derivatives
What are derivatives?
Derivative is a type of financial contract that derives its value from an underlying asset. Assets include (Bonds, Equities, Commodities, etc.)
Key Features of Derivatives are as follows:
- The buyer and seller involved in derivative contracts agree to purchase and sell an underlying asset at a specific price and at some specific future date agreed upon today.
- Derivative contracts can be used for hedging (risk management) or for speculation and arbitration.
- Assets involved in derivative contracts are stocks, bonds, commodities, currencies and interest rates.
Generally, there are four types of derivative contracts
1. Future
2. Forwards
3. Options
4. Swap
Mode of derivative Contracts:
1. Direct or (Over the Counter, OTC) Contracts.
2. Organized or Exchange Traded Derivative (ETD) Contracts.
Futures
- A Future is a derivative contract between two parties to buy or sell an asset at a specific price and at a certain time in the future agreed upon today.
- The main purpose behind the future contract is to hedge against unwanted future risk but also used to speculate on the price movements of the underlying assets.
- The future is the homogenized contracts traded on regulated stock exchanges. For example (New York Stock Exchange (NYSE), The National Stock Exchange of India (NSE), etc.
Forwards
- A forward is an unorganized derivative contract between two parties to buy or sell an asset at a specific price and at a certain time in future agreed upon today.
- The main difference between futures and forwards is that forwards are not traded on securities exchanges, rather they only trade on the Over the Counter (OTC) Markets.
- The key purpose behind the forward contract is also to hedge against unwanted future risks.
SWAP
- A Swap is a derivative contract between two parties to exchange their cash flows agreeing to trade loan terms.
- One might use the currency swap to exchange their trade between different currencies.
- One might use an interest rate swap to interchange from a fixed interest rate loan to a variable interest rate or vice versa.
- The securities will remain in the name of “Original Securities Holder”. The contract means that each party makes their payments towards the other party till maturity agreed upon today.
- Securities involved in swap contracts are – Currencies, Interest Rates or Commodities.
- Swap contracts are very risky because if one party defaults, the other party returns to their initial position before the swap contract.
Options
- An Option contract is a derivative contract between two parties in which the buyer has the right or option while the seller (Option Writer) has obligations to buy or sell the underlying assets at a specific price and at a certain time in future agreed upon today.
- In Option contracts, option writers charge a premium for taking the obligation to buy or sell the underlying assets from the Option buyers.
Popularly there are two types of Options:
Call Option
The call option gives the buyer the right to buy and the seller the obligation to sell a predefined quantity of the underlying asset at a specific price and at a certain time in future agreed upon today.
Put Option
The put option gives the buyer the right to sell and the seller the obligation to buy a predefined quantity of the underlying asset at a specific price and at a certain time in future agreed upon today.
Further options categorized based on their functionality are as follows:
American Option
- The type of option contracts which can be exercised at any time till the maturity date.
- Options available on individual securities at the NSE (National Stock Exchange) are American Options.
European Option
- The type of option contracts which can be exercised on the maturity date only.
- Options available on Indexes like (Nifty 50, Nifty Mid-Cap, etc.) at NSE (National Stock Exchange) are European options.
.png)
