Derivatives Market: Types of Derivatives

Primarily, Derivatives Market has been divided in two parts: Over-the-counter (OTC) Market and Exchange-traded Market where derivatives like Forwards, Futures, Swaps and Options are traded.

Normally, these derivatives are tool to manage risk attached to asset, but one needs to have lot of expertise to use them in their trading strategy due to their complexity. Below is the detailed explanation of the various derivative contracts.

Forwards: A forward contract is the customized contract between two parties, where settlement takes place on a specific date in future at today's pre-agreed price. Forwards represent the obligation to make a transaction at a set point in time in the future. Once you enter into a forward-based contract, you are obligated to make the transaction unless both parties agree to cancel or otherwise modify the agreement.

Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. They are unique in terms of contract size, expiry date, asset type and quality.

Forward contracts draw in counter-party risk i.e. the counter-party defaults and is unable to pay the cash difference or deliver the asset.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. When a forward contract is traded on a recognized exchange, it is referred to as a “futures contract". Examples of futures include commodities, interest rates, currencies, and stock market indices.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, an airline uses crude oil futures for hedging purpose to lock in a certain price and reduce risk. Similarly, anybody could speculate on the price movement of crude oil by going long or short using futures. Some future contracts may call for physical delivery of the asset, while others are settled in cash.

How Futures Contract work?
The futures market is a centralized market place for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery, also known as the expiry date.

Options: An option gives the contract holder the right to buy or sell on a specified date in the future - but they are under no obligation. Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Players in the Options Market:
Developmental institutions, Mutual Funds, Financial Institutions, FIIs, Brokers, Retail Participants are the likely players in the Options Market.

Some of the examples of Options are Index Options, Options on individual stocks, Bond options, Interest Rate Futures Options, etc.

Swaps: Swaps are the types of Forward contracts and they occupy an important role in International Finance. They are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They are generally an agreement to exchange one stream of cashflows to another.

Swaps have been categorised into four parts:

Interest rate swaps
Currency swaps
Commodity swaps
Equity swaps

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