Types of Derivatives

Whether you are already investing in the stock market or looking to invest your hard-earned money in the sprawling stock market, it is necessary for you to understand that such investments carry a high level of risks. The rapid fluctuation of the stock prices tends to break or build people’s lives. This is why it is highly recommended to take one such investment decision carefully.

There are different securities that one can choose to invest in like bonds, currency, commodities, and equity etc. At the same time, there are various instruments that are meant to safeguard investors from the high volatility of the markets and are quite useful. These instruments not keep the risk balanced to the investors but also offer guarantees to them. They are called derivatives.

In this post, we will cover the meaning of derivatives, how they help investors, the type of derivatives and other relevant topics.

What are derivatives?

A derivative usually means a kind of financial security that holds a worth dependent upon or extracted from, a fundamental asset or clusters of assets—a benchmark. The derivative can also be termed as a contract between two or more entities, and it stems its price from variations in the fundamental asset.

The most widely preferred fundamental assets for derivatives include bonds, stocks, currencies, commodities, interest rates, and market indexes. These assets are usually bought through brokerages.

Key Takeaways

  • Derivatives are widely characterized by the association between the fundamental asset and the derivative, the kind of asset, the trading market, and their pay-off outline.
  • The most commonly used derivatives are options, futures, forwards, and swaps. The most collective primary assets are bonds, stocks, commodities, currencies, and interest rates.
  • Derivatives enable stock investors to gain big-size returns from minor variations in the fundamental asset’s value. Contrariwise, investors tend to shed off large amounts if the asset’s price drops considerably.

Why do investors use derivatives?

There are various reasons why investors prefer to use derivatives:

  • To envisage and accrue profits if the price of the fundamental asset behaves in a manner they expected.
  • To offer leverage so that a small change in the value of the asset can cause a big change in the value of the derivative.
  • To verge or alleviate risk in the original, by commencing a derivative contract whose price shifts in the opposite route to the original position and abandons a portion or all of it out.
  • To bring in option ability where the price of the derivative is associated with a particular condition or event.
  • To get exposure to the fundamental asset when it seems impossible to trade.

Types of Derivatives

Let’s have a look at the most common types of derivatives:

  1. Forwards

Forward contracts or just Forwards refers to when two entities come together and make entry to an agreement in order to buy and sell a fundamental asset set at a predicated date and settled on a price in the future.

In simpler terms, it is a contract formed between both entities who decide to sell their asset in the future. The forward contracts can be modified and carry a high propensity of counterparty threat. As it is a tailored agreement, the scale of the agreement basically depends on the contract term.

Here, it is to note that forward contracts do not need any kind of security as they are self-governed. The settlement of the forward contract is finished on maturity, and therefore they remain effective within the expiry period.

  1. Futures

Futures contracts or futures—denote a contract between two parties for the buying and selling of an underlying asset at a fixed price on a future date. Futures are usually traded on an exchange, and the agreements remain standard Traders tend to use a futures contract to mitigate their risk or venture on the value of a fundamental asset. The parties included in a futures contract are indebted to achieve a commitment to buy or sell the fundamental asset.

The counterparty risks are low in futures due to the standardization of the contract. Moreover, all the deals are done through the exchange only. As these agreements are standard, the futures contracts mounted on the stock exchange cannot be altered or reformed in any manner.

  1. Options

An options contract is very much like a futures contract. In such an agreement, there are two parties to buy or sell an asset at a prefixed date and price in the future. The major point of difference between options and futures is that, in the case of option, the buyer is not indebted to practice their contract to buy or sell. It is just a prospect, not a compulsion—futures mean commitments. Just like futures, options may be employed to verge or guess the price of the fundamental asset.

There are two types of option contracts: Call and Put.

In case of call, the buyer has the authority to buy an underlying asset at a standard price while signing the contracts. Whereas in the put option, the buyer carries all the rights but not compulsion to sell the fundamental asset at a fixed price during the contract.

  1. Swaps

Among these four types of derivatives, swaps are considered the most complex ones. This type of agreement is executed securely between two parties. The parties who choose to get into swap contracts decide to exchange their cash stream in the future as per the preset equation.

In the case of swap contracts, the fundamental asset refers to the interest rate or currency, as these contracts safeguard both parties from bigger threats.

These contracts are traded in the Stock Exchange due to the involvement of an investment banker who acts as a middleman between these contracts.

Pros and Cons of Derivatives

Pros                                                                                                                Cons

Price lock in                                                                    Difficult to value

Privet against risk                                                         Dependent on counterparty default

Portfolio diversification                                               Hard to determine

Option to leverage                                                       Subtle to demand and supply

FAQs

What are derivatives?

Derivatives refer to financial contracts that secure their wroth from a cluster of underlying assets.

How many types of derivatives are there?

There are primarily four types of derivatives – Futures, Options, Forwards, and Swaps.

What are the issues related to forward markets?

Forward markets globally are affected by various problems: lack of centralism in trading, illiquidity, and counterparty risk.

What does the expiration date mean?

It refers to the last day on which the contract is scheduled to expire. Futures and Options contracts are found to perish on the last Thursday of the expiry month. If the last Thursday is a holiday, the contracts get expired on the previous trading day.

Is there any payable margin payable?

Yes. Margins are measure and accrued online, real-time on a portfolio basis at the client-side. Members are supposed to gather the margin straight from the client & notify the same to exchange.

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