Derivatives

Investors put their money into the financial market with the hope that they will make good returns. However, the investment may turn risky due to volatility within the prices of securities such as those of equity, currency, commodities, and others. As a result of these fluctuations, all predictions could go one of two ways. This raises one’s chances of wiping out their entire set of investments. For this reason, the main concern of traders is that of the risk associated with the flow of returns in financial markets, especially when they are trading regularly.

To appeal to varying interests, there are a variety of instruments available on the market that can protect a trader from the volatility and risks of financial markets. Such instruments not only protect traders but also guarantee a potential yield. Such instruments are derivatives. The fact is that it is surprising to learn just how many types of derivatives exist. In this article, we will learn about the concept of derivative securities and the different types of financial derivatives that one can consider investing in. But first, what exactly is meant by derivatives?

What are derivatives?

Financial contracts that earn their value from that of the underlying asset are known as derivatives. The value of derivatives keeps on changing depending upon market conditions. Derivatives can be traded by predicting the underlying asset’s future price movement. Derivatives contracts are often used to make good returns while speculating. Derivative securities can be utilized for a variety of purposes such as access to additional assets, hedging, and more. Now let’s take a look at the different varieties of derivates in India.

Types of derivatives in India

There are four different types of derivates in India that can conveniently be traded on the Indian stock markets. Each differs from the other while having different contract conditions, risk factors, and more. The different derivative securities types are

• Future Contracts
• Options Contracts
• Forward Contracts
• Swap Contracts

We will take a look at each of these types of currency derivatives contracts in detail.

1. Futures Contracts

Similar to a forward contract, a futures contract is an agreement that involves buying or selling an underlying instrument at a future date at some specified price. In the futures contract, both the seller and the buyer choose to enter into an agreement that states as follows. The agreement that is between them via the futures contract is an exchange. As there is a standardized contract in a futures contract, the risk for counterparty is quite low. Additionally, the clearinghouse will serve as the counterparty for both parties of the contract which will further minimize credit risk.

Being a contract that is standardized, a forward contract is fixed and also regulated by the stock exchange, Futures contracts are listed on the stock exchange and are standardized in nature, which is why they cannot be modified in any way. To keep it simple, these contracts have a format that is pre-decided in terms of their expiration date, and size. In a futures derivative securities contract, an initial margin is often required as collateral, while a settlement is carried out on a daily basis.

2. Options Contracts

An options derivatives contract is the second type of derivatives contract out there. This type of derivative is quite different from both the future and forward contracts mentioned earlier, as there it is not mandatory to dispense with the contract on a certain predecided date. Hence, options contracts are those types of contracts that give the trader the right without the obligation to either sell or buy an underlying asset. There are two different types of options: put or call options. In the call option, the buyer receives the right to purchase an asset at a price that is predetermined when they are entering the contract.

Alternatively, with the aid of a put option, the buyer has the opportunity but not the obligation to sell some underlying asset at a predetermined rate when she or he chooses to enter into the contract. In both of these contracts, the buyer receives the option to settle their contract either on or before the expiry period. Hence, anyone that is trading in the options contract can take any one of four positions — either call or put options with long or short positions in either. Options derivates are traded at the stock exchange and over the counter market.

3. Forward Contracts

Let’s assume two trading parties enter into an agreement where they either sell or buy an underlying asset at an agreed price at some future date. This is a forward contract. Sounds familiar? A futures contract is very similar to a forward contract. In a forward contract, both parties have the agreement to sell some underlying security at a future date. Forward contracts are customized to possess a decent amount of counterparty risk, which depends upon the term and size of the contract. Unlike futures contracts, however, there is no collateral necessary for a forward derivative securities contract, as they are self-regulated. Forward contracts derivates in India are settled on their maturity date, and they must, hence, be reversed by the time their expiry period approaches.

4. Swap Contracts

These are probably the most complicated types of derivates in India. In general, a swap contract is a private agreement between two trading parties. Both parties in the contract choose to exchange their cash flow at some point in the future as per a predetermined formula. The currency derivates underlying a swap contract is either an interest rate or currency itself- both of which are volatile in nature. Hence, swap contracts tend to protect parties from various risks. Such types of derivative securities are not traded on public exchanges. Instead, investment bankers serve as the middlemen for these transactions.
 

Advantages of Derivatives 

Hedging Risks

Hedging risk is to reduce risk in one’s investment by making another investment and derivatives are the best option to do so. Derivatives are used as an insurance policy to reduce risk and it generally is used with the objective of minimizing risk in the market. It is clear from the above example that the corn farmer and the buyer derivatives were used to hedge price risk by locking in the price of corn. 

Low Transaction cost

Trading in the derivatives markets includes low transaction cost as compared to other securities like shares or bonds. As derivatives basically act as a risk management tool it ensures lower transaction cost.

Disadvantages of Derivatives

High Risk

As these instruments derive their value from the underlying asset, changes in the value of the underlying impacts these contracts immensely. The prices of the underlying like shares, bonds etc keeps changing according to market conditions and are unpredictable.

Speculative nature

Derivatives are the common tool used for speculation in order to earn profits. The unpredictable nature of the market makes speculation highly risky and may result in huge losses.