Types of Derivatives

There are four main types of derivatives: forward contracts, futures contracts, options contracts, and swap contracts.
Types of Derivatives
3 mins read
29-June-2024

Derivatives provide investors with tools to manage risk and enhance portfolio returns. In the Indian securities market, derivatives have gained immense popularity and are widely used by investors, traders, and institutions alike. This article delves into the various types of derivatives available in the Indian context, shedding light on their characteristics, uses, and significance.

What are derivatives?

Derivatives are financial instruments whose value is derived from the value of an underlying asset, such as stocks, bonds, commodities, currencies, or market indices. These instruments enable market participants to hedge against risks and optimise investment strategies. Derivatives are traded on exchanges or over-the-counter (OTC) markets and come in various forms, including futures contracts, options contracts, forward contracts, and swap contracts.

Types of derivatives in India

Let us explore different types of derivates in India:

1. Futures contracts

Futures contracts are standardised agreements to buy or sell a specified asset at a predetermined price on a future date. In India, futures contracts are prevalent in equities, commodities, and currencies. These contracts are traded on derivative exchanges such as the National Stock Exchange (NSE) and the Multi Commodity Exchange (MCX). Futures contracts allow investors to hedge against price fluctuations, track market movements, and leverage their positions. However, they entail the obligation to buy or sell the underlying asset at the agreed-upon price, which exposes traders to market risk.

2. Options contracts

Options contracts provide the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price within a predetermined time frame. In India, options are widely traded on stocks and indices. Options offer investors flexibility and downside protection, as they can limit losses to the premium paid for the option. Moreover, options allow traders to profit from both rising (call options) and falling (put options) market trends. However, options trading involves the risk of losing the entire premium paid if the option expires out of the money.

3. Forward contracts

Forward contracts are customised agreements between two parties to buy or sell an asset at a future date at a price determined today. Unlike futures contracts, forward contracts are traded over-the-counter (OTC) and are not standardised. In India, forward contracts are prevalent in commodities such as agricultural products and metals. Forward contracts are highly customisable, allowing parties to tailor the terms to their specific needs. However, they expose participants to counterparty risk, as there is no centralised clearinghouse to guarantee performance.

4. Swap contracts

Swap contracts are financial agreements between two parties to exchange cash flows or other financial instruments based on predetermined terms. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. In India, swap contracts are primarily used by institutions to manage interest rate and currency risks. Swaps allow parties to hedge against fluctuations in interest rates, exchange rates, or commodity prices, thereby reducing exposure to market volatility. However, swap contracts involve credit risk and may require collateralisation to mitigate potential losses.

How to trade in the derivatives market?

Here is a rephrased version focusing on key steps for effective derivatives trading:

1. Open a trading account

You'll need an online trading account to access derivatives markets. Brokers may also offer phone or online order placement.

2. Understand margin requirements

Derivatives require a margin deposit, a portion of the contract value you must hold upfront. This cannot be withdrawn until the trade closes. A margin call occurs if your margin falls below a minimum, requiring you to add more funds.

3. Research the underlying asset

Derivatives are based on another asset (e.g., stocks, commodities). Solid understanding of this underlying asset is crucial for informed trading decisions.

4. Manage your risk

Carefully consider your budget. Ensure it covers margin requirements, cash reserves, and contract costs. Don't risk more than you can afford to lose.

5. Develop an exit strategy

Plan your trade exits. Do not hold contracts indefinitely, even when using online trading platforms.

Conclusion

From futures and options to forwards and swaps, the Indian derivatives market offers diverse opportunities for participants to hedge and optimise their portfolios. However, it is essential for investors to understand the characteristics and risks associated with each type of derivative before engaging in trading or investment activities.

In conclusion, derivatives serve as indispensable tools for risk management and price discovery in the Indian securities market, contributing to liquidity, efficiency, and stability. By leveraging derivatives effectively, investors can navigate volatile market conditions and achieve their financial objectives with confidence.

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Frequently asked questions

What are the 4 main types of derivatives?
  • Futures contracts: These are standardised agreements to buy or sell an underlying asset (such as stocks, commodities, or currencies) at a predetermined price on a specified future date. Futures contracts are widely used for hedging.
  • Options contracts: Options provide the right (but not the obligation) to buy (call option) or sell (put option) an underlying asset at a specific price within a specified time frame. They offer flexibility and are commonly used for risk management.
  • Swaps: Swaps involve the exchange of cash flows based on interest rates, currency exchange rates, or other financial variables. Common types include interest rate swaps and currency swaps.
  • Forwards contracts: Similar to futures, forwards are customised agreements between two parties to buy or sell an asset at a future date. Unlike futures, forwards are not standardised and are typically traded over-the-counter (OTC).
What are some examples of derivatives?
  1. Stock index futures: These allow investors to leverage on the future direction of stock market indices (for example, Nifty 50 or Sensex).
  2. Call and put options: Investors can use call options to profit from rising prices and put options to hedge against price declines.
  3. Interest rate swaps: Banks and corporations use interest rate swaps to manage interest rate risk.
  4. Currency futures: Traders can leverage on currency exchange rate movements using currency futures.
Are option contracts different than future contracts?
  • Options provide the right (but not the obligation) to buy or sell an asset, while futures contracts require both parties to fulfil the contract.
  • Options have limited risk (premium paid) and unlimited profit potential, whereas futures have symmetric risk (both upside and downside).
  • Options are more flexible, allowing investors to choose whether to exercise the contract, while futures are standardised and settled at maturity.
What are the top 5 derivatives?

While there are many derivatives, some of the most popular include:

  1. Options contracts: Grant the right, not the obligation, to buy or sell an asset at a specific price by a certain time.
  2. Futures contracts: Agreements to buy or sell an asset at a predetermined price on a specific future date.
  3. Swaps: Agreements to exchange cash flows between two parties based on an underlying interest rate, commodity, or currency.
  4. Forward contracts: Similar to futures contracts, but customized and traded over-the-counter (OTC) rather than on exchanges.
  5. Credit Default Swaps (CDS): Contracts that protect against the risk of default on a loan or bond.
What are the three financial derivatives?

Technically, all derivatives are financial instruments. However, focusing on the most common types used in financial markets, the top three would be:

  1. Interest rate derivatives: Options, futures, and swaps based on interest rates, used to manage interest rate risk.
  2. Equity derivatives: Options, futures, and swaps based on stocks or stock indices, used for hedging or speculation on stock prices.
  3. Currency derivatives: Options, futures, and swaps based on foreign currencies, used to manage foreign exchange risk.
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