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What is a Derivative and Its Types

Derivatives are one of the most popular segments in the Indian financial markets in terms of trading volume. There are different types of derivative markets that you can trade in. This includes equity derivatives, commodity derivatives, and currency derivatives. Want to trade in derivatives but are unsure where to start? This simple, yet comprehensive guide can help you understand these unique financial products.

What is a Derivative

A derivative can be defined as a financial contract between two or more parties. The value of such a contract is dependent on the value of an asset called the underlying asset. Since the contract essentially derives its value from that of the underlying asset, such contracts are referred to as derivatives. 

Derivatives are often used to protect oneself from price risk, which is the risk of the price of an asset falling in the future. This process is known as hedging. Alternatively, derivatives can also be used for speculation, which involves using the price movements of an asset to generate profits. 

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What are the Types of Derivatives

In India, there are four primary types of derivative contracts that you can enter into. This includes forward contracts, futures contracts, options contracts, and swap contracts. Here’s a quick overview of each one of these types. 

1. Forward Contracts 

A forward contract is when two or more parties sign a formal agreement to purchase or sell an asset at a predetermined date in the future at a set price. Forward contracts are generally very customized and have no standardized terms. And since the contract itself is customized to fit the requirements of the parties involved, they are not traded on any exchange. Unlike other derivatives, forward contracts are not regulated by any authority. This is a major drawback since there would always be the risk of the counterparty failing to fulfil its end of the contract. 

Here’s an example to help you understand forward contracts in a better manner. Assume that you’re a wholesale trader dealing in wheat. Since the price of wheat has been very volatile, you choose to enter into a forward contract with a farmer in a bid to protect yourself from possible increases in the commodity’s price in the future. The farmer also agrees to the forward contract in a bid to protect himself from a possible decline in the commodity’s price in the future. 

According to the contract’s terms, you agree to purchase 100 sacks of wheat at Rs. 4,000 per sack two months later. The market price of wheat on the day you entered into the contract was Rs. 3,900. Two months pass and as agreed upon, the farmer delivers the 100 sacks of wheat. The price per sack of wheat on the delivery date is Rs. 4,200. 

Now, as you expected, the price rose by Rs. 300 (Rs. 4,200 - Rs. 3,900). But by entering into a forward contract you effectively hedged the risk and saved Rs. 200 (Rs. 4,200 - Rs.4,000) per sack. However, the farmer lost Rs. 200 per sack by entering into this agreement. If the price had instead fallen, you would have made a loss and the farmer would have made a profit. With a forward contract, it is usually only one party that gains. 

2. Future Contracts 

When two parties agree to buy or sell a particular instrument at a predetermined price and date, such an agreement is termed a future contract. As you can see, a future contract is very similar to a forward contract. Futures are one of the most common types of derivatives in the Indian financial markets. 

However, despite the similarities, there are quite a few differences between future and forward contracts. Let’s take a look at a few of the key features of a futures contract.

  • Unlike a forward contract, a futures contract is entered into online through an exchange. The buyers and the sellers of the contract don’t meet each other. 
  • A future contract is standardized and not customizable. An asset can only be bought or sold in set numbers (lots). The exchange sets the minimum lot size for the asset in question. 
  • Even the expiry date of the contract is standardized and predetermined. 
  • A future contract is heavily regulated by the stock exchange. This ensures that there’s no counterparty risk and that all parties comply with their end of the bargain. 
  • To enter into a future contract, both the buyer and seller of the contract are required to deposit a fraction of the total value of the contract as a margin. This acts as a kind of security deposit to protect against default risk. As and when the value of the futures contract changes, the margin is revised with either the buyer or the seller having to deposit more margin to keep the contract open and active. 

3. Options Contracts

Another one of the most popular types of derivatives in India, options contracts also deal with the purchase or sale of the underlying asset at a predetermined price and date. However, they’re very different from future and forward contracts. 

For instance, in a future or forward contract, both the buyer and seller are obligated to follow through with their end of the bargain. However, in an option contract, the buyer of the option gets the right to purchase or sell the underlying asset at the predetermined price and date. However, the buyer may choose to not exercise the contract, in which case it would expire worthless. The seller of the option, on the other hand, is obligated to purchase or sell the underlying asset on the agreed-upon date and price. The seller cannot back out of the contract after entering into it; that option rests with the buyer alone. 

There are two kinds of options contracts that you can enter into - call options and put options. A call option gives the buyer the right to purchase the underlying asset at a specific price on a future date. A put option gives the buyer the right to sell the underlying asset at a specific price on a future date. 

4. Swap Contracts

A swap contract is where two parties agree to exchange or ‘swap’ their revenue streams or cash flows arising from their respective assets. Similar to a future contract, swaps are also very customized and are not traded on an exchange. Due to this, they suffer from counterparty risk. 

There are three kinds of swaps that entities generally enter into - interest rate swaps, currency swaps, and hybrid swaps. In an interest rate swap, two parties exchange the cash flows arising from their respective fixed-interest debt instruments. In a currency swap, two parties exchange the cash flows in two different currencies. And finally, in a hybrid swap, two parties exchange cash flows from different instruments and in different currencies. 

Conclusion

Derivatives might seem like complex financial instruments. However, once you get the hang of it, it becomes relatively easy to understand. If you wish to trade in derivatives, futures and options are currently the only two types of derivatives that are available for retail traders such as yourself. 

But then again, to trade in such contracts, you need to first open a demat account and a trading account. It is a mandatory requirement. If you wish to open a trading and demat account in no time, simply visit Motilal Oswal. You can complete the entire account opening process online and have your account activated in no time. 

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