People invest money in the financial market with the hope of making good returns. But the investment may turn risky due to volatility in the prices of securities like commodities, currency, equity, etc. During such fluctuations, all the predictions could go either way. This increases the chances of wiping out your entire investments. Thus, the primary concern of the trader is the risk that is associated with the financial market and flow of returns while trading in the market.
There are various instruments available that can protect a trader from the risks and volatility of the financial markets. These instruments not only protect the traders but even guarantees returns to them. Derivatives are such instruments. In fact, you will be surprised to know about just the types of derivatives market that exist. In this article, we will understand the concept and different types of financial derivatives in detail.
Before understanding the types of financial derivatives, let us first learn the meaning of derivatives.
What are Derivatives?
Derivatives are financial contracts that derive their value from an underlying asset. The value of the underlying asset keeps on changing depending on the market conditions. The derivatives can be traded by predicting the future price movement of the underlying asset.
The derivatives contracts are widely used to speculate and make good returns. These are used for various purposes like hedging, access to additional assets, etc.
Let us now learn about the different types of derivatives market in India.
Different Types of Derivatives in India
There are four types of derivatives that can be traded in the Indian stock market. Each type of derivative differs from the other and has different contract conditions, risk factor, etc. The different types of derivatives are as follows:
• Forward Contracts
• Future Contracts
• Options Contracts
• Swap Contracts
Let us now study the different types of financial derivatives in detail.
• Forward Contracts
When two parties enter into an agreement to buy or sell an underlying asset at a specified date and at an agreed price in the future, it is termed as a forward contract. Forward contracts are an agreement between the parties to sell something on a future date. The forward contracts are customised and have high counterparty risk. Since the contract is customised, the size of the contract depends on the term of the contract. Forward contracts are self-regulated and no collateral is required for the same. The forward contract's settlement is done on the maturity date and hence they must be reversed by the expiry period.
• Futures Contracts
Just like the forward contract, a futures contract is an agreement to buy or sell an underlying instrument at a specified price on a future date. In the futures contract, the buyer and seller are not required to meet each other to enter into an agreement. In fact, the agreement between them is done via exchange. Since there is a standardised contract in the futures contract, the counterparty risk is very low. In addition, the clearing house acts as a counterparty to the parties of the contract which further reduces the credit risk. Being a standardised contract, its size is fixed and it is regulated by the stock exchange. Since the future contracts are listed on the stock exchange and being standard in nature, these contracts cannot be modified in any way. To put it in simple words, future contracts have pre-decided format, pre-decided expiry period and pre-decided size. In future contracts, initial margin is required as collateral and settlement is done on a daily basis.
• Option Contracts
Options contracts are the third type of derivatives contract. Options contracts are very different from futures and forwards contracts as there is no compulsion to discharge the contract on a certain date. Options contracts are those contracts that give the right but not the obligation to buy or sell an underlying asset. There are two types of options: call and put. In the call option, the buyer has the right to buy an underlying asset at a price determined while entering the contract. While in the put option, the buyer has the right but not the obligation to sell an underlying asset at a price determined while entering the contract. In both the contracts the buyer has the option to settle the contracts on or before the expiry period. Therefore anyone trading in the options contract has the option of taking any of the 4 positions i.e. long or short in either the put option or the call option. Options are traded at over the counter market and at the stock exchange.
• Swap Contracts
Out of the various types of derivatives contracts, swap contracts are the most complicated. Swap contracts are private agreements between two parties. The parties to the contract agree to exchange their cash flow in the future as per a predetermined formula. The underlying security under swap contracts is interest rate or currency. Since both interest rate and currency are volatile in nature, it makes swap contracts risky. Swap contracts protect the parties from various risks. These contracts are not traded on the exchanges and investment bankers are the middlemen to these contracts.
To conclude, derivatives contracts like forwards, futures and options are one of the best hedging instruments. The traders can predict future price movements and make good profits out of them. For further assistance regarding derivatives contracts trading, you can contact IndiaNivesh who can assist you with trading in derivatives.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.