A derivative is a financial instrument that gets its value from an underlying asset. The underlying security could be shares, bonds, currencies, commodities, and more. These financial instruments are relatively intricate tools that many may find it hard to comprehend. Investors or traders primarily use these instruments for hedging and speculation purposes. Since the price of derivatives depends on the underlying security, an investor can profit by currently predicting the price of the underlying asset. There are mainly four types of derivatives.
Similar to shares, investors can trade derivatives contracts as well. Some derivatives contracts trade over-the-counter (OTC), while some trade on recognized exchanges. Some of the biggest derivatives exchanges in the world are the CME Group, Eurex, and the Korea Exchange. Now we will detail the types of derivatives.
Types of Derivatives
Following are the types of derivatives:
These are the oldest and simplest types of derivatives. In this, the buyer or the holder of the forward contract enters into an agreement to buy the underlying asset at a specific rate and at a specific date in the future. Such types of contracts give holders more flexibility than any other types of derivatives. This is because such contracts are customizable, and thus, traders can customize the price and expiry date of such contracts.
Such types of derivatives trade on OTC, and thus, it is a direct contract between two parties. Since there is no involvement of exchange, these contracts carry higher counterparty credit risk. The terms of the forward contracts remain as decided between the two parties, who may or may not make it public. We also call such contracts as ‘forward commitment’ because the parties do not get the right to cancel the contract.
Suppose Mr. A owns a car and plans to sell it a year later. On the other hand, Mr. B plans to buy a car a year later. The two can enter into a forward contract to buy and sell the car a year later at an agreed price.
The working modalities of futures contracts are like that of a forward contract. Similar to forward contracts, these agreements are also an obligation for the parties. The only difference and exception between the two are that futures are standardized contracts that trade on established exchanges. Thus, the parties to a futures contract can not tailor the contractual points. Also, unlike the forward contracts, the buyer and seller do not enter into a contract with each other directly. Instead, they enter into a contract with the exchange. Moreover, all such contracts and their terms and conditions are no more private as it is an exchange-traded contracts.
Futures contracts have a fix format, size, and expiration. As all these contracts are traded on the exchange, they follow the exchange’s standard daily settlement process. This means the losses and gains settle on a daily basis. Such procedures help to reduce the counterparty credit risk.
For example, Mr. A expects the price of Company X shares to go up in the near future. Thus, Mr. A buys a Company X futures at the current price. Now, if the price of shares goes up in the future, Mr. A would still be able to buy Company X shares at less than the market price.
These are the most popular types of derivatives. Unlike forward and futures contracts, options give the holder the right to act. But he is under no obligation to exercise his right to buy or sell the underlying asset at a specific rate and date. In case of an option, the right is only available to the buyer. For the seller, however, options are an obligation. It means that the seller would have to fulfill the contract if the buyer exercises the option.
Options have two variants – the call option and the put option. The call options give the holder the right (not obligation) to acquire the underlying asset at a future date and at a specific price. The opposite is the status of a put option. Thus, the put option holder has the right (not obligation) to sell an underlying asset at a future date and at a specific price.
So, we can say that investors have 4 choices for trading options. They can be buyers or sellers of either the put or call option. The buyer of the option has to pay a charge or fee, and we call it the option premium.
Also, there are three different types of options on the basis of expiry – European, American, and Bermudan. Depending on the type (European, American, and Bermudan), the holder can either exercise the option on the expiry or before the expiry.
Swaps are the most intricate derivative tools. These derivatives allow parties to exchange or swap the cash flows. Most swaps involve the exchange of fixed cash flow for a floating cash flow. Similar to other types of derivatives, swaps can be of commodity, currency, interest rate, or more. Interest rate swaps are the most common types of swaps.
For example, a bank holds a home mortgage for a variable rate, but it wants to protect itself from the interest rate fluctuations. For this, the bank would swap its variable rate mortgage with a fixed-rate mortgage of someone else.
CDS (credit default swap) is a popular type of swap. This swap bets on the risk of default of debt, or we can say that it works like insurance against the risk of default of a debt instrument. For instance, a buyer of CDS bets that the underlying credit instrument will have a default.
Swaps, generally, do not trade on any exchange. They are a private agreement in that two parties negotiate directly with each other. Thus swaps do carry a high amount of credit risk.
For example, Company A is an Indian firm that plans to export shirts to the U.S. For this, it takes a loan from an Indian Bank. Here Company A will be earning in USD but will make interest payments in Indian Rupee. This may result in a currency exchange rate risk.
To overcome this, Company A could enter into a swap agreement with a U.S. company that is planning to enter the Indian market. In this case, the U.S. company (earnings in Indian Rupees) would service the Indian company’s debt. And the Indian company would service the U.S. company‘s debt in the U.S.
All the types of derivatives are a good investment avenue for experienced investors to put their surplus funds. Also, derivatives are popular instruments among hedgers. However, investors in derivatives must fully understand derivatives markets and instruments, as well as their consequences.