Derivatives and its types

The term ‘Derivative’ stands for an agreement which derives its price from or is dependent upon an underlying asset. The underlying asset can be a financial assets like currency, stock and market index, an interest bearing security or a physical commodity. Derivative contracts are traded on electricity worldwide today.

Financial derivatives have emerged as one of the biggest markets of the globe during the past two decades. A rapid change in technology and has acted as a key vehicle for information processing in financial markets. Globalization of financial markets has forced several countries to change laws and introduce innovative financial contracts which have made it easier for the participants to undertake derivatives transactions.

A group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848 gave birth to the concept of Derivatives. In 1865, the CBOT went one step further and listed the first ‘exchange traded” derivatives contract in the US. These contracts were called ‘futures contracts”.

Types of Derivative Contracts

Derivatives consists of four basic contracts namely Forwards, Futures, Options and Swaps.

1. Forward Contracts: These are agreements to deliver an asset at a pre-determined date in future at a predetermined price. Forwards are highly popular in currencies and interest rates. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties.
2. Futures Contracts: A futures contract is an agreement within two parties to buy or sell an asset at a certain time in future at a certain price. They are exchange traded, standardized contracts. The exchange stands guarantee to all transactions. The counter party risk is significantly eliminated.The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. Futures contracts are available on commodities, currencies, interest rates, stocks and other tradable assets stock indices, interest rates and foreign exchange.
3. Options Contracts: Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future. 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.
4. Swaps: Swaps are private contracts between two parties to exchange cash flows in the future according to a prearranged formula. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

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