What Are the Types of Derivatives

Types of Derivatives

If you have heard of stock markets and trading, you have also heard of derivatives. Some call it by the more colloquial name of futures and options or F&O. Remember, futures and options are just two of the derivative types and there are many more. There are derivatives on stocks, there are derivatives on bonds, there are derivatives on indices and there are also derivatives commodities.

Before we get into the types of derivatives in specific, the concept has to be understood. Derivatives are called thus because they do not have any value on their own. They derive their value from an underlying asset like stocks, bonds, commodities or indices. When you are trading in derivatives, you are depending on these underlying assets, which determine the returns on derivatives. In India, the derivatives options market is extremely large and liquid. Let us look at in detail at the types of derivative markets overall.

Concept of derivatives

Before we go into the types of derivatives, let us dwell a little more on the concept of derivatives and how they are structured. Unlike equities or bonds, derivatives are not assets. Instead, these derivatives are financial contracts that earn their value from an asset or a group of underlying assets. Since they derive their value from an underlying asset or an underlying group of assets, they are called derivatives. As the value of the underlying asset changes, the value of the derivative also changes, depending on the structure of the contract. For example, if price of a stock goes up, then the underlying call option becomes more valuable and the underlying put option becomes less valuable. But, more later.

Derivatives can be used for a number of purposes. It can be used to trade by taking a big bet on price movement. It can be riskier and normally trading in derivatives is riskier. The other very important purpose of derivatives is to protect the risk or the downside risk. For instance, if you are holding a stock, then you can hedge the fall below a certain price with the help of derivatives. Derivatives can also be used to earn riskless profits by arbitraging between the spot market and the cash market, something that is called arbitrage. This is possible in equity markets and also in commodity markets. What you need to know is that derivatives are not assets but contracts. The value of the derivative can go up or go down very sharply based on how the underlying asset moves. Derivatives can be used either to enhance and magnify your profits or to protect your downside risks or losses.

Here Are The 4 Derivatives Types

Broadly, there are 4 different types of derivatives contracts. There are many combinations and hybrid products by combining these 4 products, which we will not get into at this point of time. Here are the 4 broad types of derivatives.

• Forward Contracts 
• Future Contracts 
• Options Contracts 
• Swap Contracts 
Structurally, a forward and future contract are almost the same, although there is a subtle difference as we shall see later. However, in the case of options and swaps, the payoffs and the structure is entirely different. Let us look at each of these contracts in detail.

1) Forward Contracts

In a forward contract, two parties enter into an agreement to buy and sell an underlying asset at a fixed date and at an agreed date in the future. For instance, a tomato farmer and a ketchup factor can get into an agreement wherein the farmer supplies a fixed quantity of tomatoes to the ketchup factory. The farmer commits to supply the said quantity of tomatoes to the ketchup factory and the ketchup factory agrees to take up that quantity. On the day of the contract, if the price has gone below the contracted price, then the farmer gains and the ketchup factory loses. On the other hand, if the price is above the contract price, then the ketchup factory gains and the farmer loses.

For both; the buyer and the seller in a forward contract, it is a commitment to buy and to sell a certain quantity at a certain price on a certain date. Forward contracts are very customized and normally entered into between 2 parties with specific needs, as in the case of the farmer and ketchup factory above. However, a forward contract has some limitations. It is illiquid since it is customized. If one of the party cannot fulfil the agreement, the other party only has a legal recourse. That is called counterparty risk. It is this risk of liquidity and counterparty default that is overcome by the Futures contract, which we shall look at in the next section.

2) Futures Contract

The futures contract is similar to forward contracts, the only difference being that it is more structured. Like the forward contract, the futures contract is also an agreement between 2 parties to buy and sell an underlying assets at a fixed price and at a future date. However, unlike in a forward contract, the buyer and seller are anonymous in a futures contract. That is because the futures contracts are exchange traded and it is based on the order matching system. However, unlike the forward contract, the futures contract is standardized. For example, you can only have 3 futures contracts on Reliance Industries with similar lot size and similar expiry dates. Because it is standardized and exchange traded, all the trades in the futures market are counter guaranteed by the clearing house of the stock exchange. Hence there is zero counterparty risk in futures. Unlike in forwards, if one of the party defaults in a futures contract, the exchange clearing house will fulfil that contract.

3) Options Contracts

Options are slightly more complex compared to forwards and futures. While forwards and futures are symmetric contracts, options is an asymmetric contract. That means, the rights and obligations of the buyer and seller of options are not the same. An option is a right to buy or sell an underlying asset. The buyer of the option gets the right and the seller of the option gives the right. The risk of the buyer of an option is limited to the premium paid, while the risk of the seller of the option contract can be unlimited. What is this premium? In an option the buyer gets the right and the seller gives the right. Premium is the price of that right, which is a sunk cost paid by the buyer of the option to the seller of the option.

Options can be of 2 types viz call option and put option. A call option is a right to buy and underlying asset and a put option is the right to sell an underlying asset. There would be effectively the buyer of a call option and seller of a call option. There will also be the buyer of a put option and seller of a put option. Remember, in options, we are not trading in assets but in the right to buy (call) or the right to sell (put) an asset.

Options have strikes and expiries that are standardized. The strikes are the contract prices on which rights to buy and sell are traded in the market.

4) Swap Contracts

Among all the derivatives contracts, swap contracts are very complex. A swap means an exchange. Literally a swap contract is about exchange one set of cash flows for another set of cash flows. For example, if you are an exporter and expecting a stream of payment in dollars, you can swap it for payments in pounds or Euro if that is more attractive. Similarly, if you have fixed interest pay-outs, you can swap that into variable interest pay-outs linked to ta benchmark rate.

Swap contracts are over the counter (OTC) contracts and not traded on exchanges. They are done privately between parties. Typically, the underlying assets in a swap contract are either the currencies or interest rates. Normally, such swaps are structured by specialists and to avoid the counterparty risks only large institutions participate in swaps.