Derivatives is the term used in the context of financial markets, it refers to those instruments which derive their value from other asset classes and they themselves have no value and the price of derivative is dependent on the value of underlying asset. Let’s look at various types of derivatives which are there in the market –
- Futures – Futures refers to standardized contract through which the parties to contract agree to buy or sell specific asset at predetermined future date and both buyer and seller will be under obligation to complete the transaction and therefore under future the risk arising from contract is unlimited both for buyer as well as seller because price may move unfavorably for either of them. It can be better understood with the help of an example, suppose A and B enter into 1 month future contract of Microsoft stock now if the current market price of Microsoft stock rises then buyer will be in profit as price of future contract will also rise and seller will have to face the loss and opposite will happen in case the current market price of Microsoft stock decline.
- Options – Under options there is a contract between the buyer and seller through which the buyer get the right but there is no obligation to buy or sell an asset at particular price and at particular time. Under option buyer of options is at advantage as loss of buyer is limited to premium paid by him or her for purchasing the option where the loss of seller is unlimited and profit is limited to the extent of premium received from buyer. Options are of two types one is call option which gives buyer of call option right to buy an asset at predetermined price no matter what current market price is and other is put option which gives the buyer of put option to sell an asset at predetermined price no matter what current market price is, call option holder will benefit if the price of asset rise and put option holder will benefit if the price of asset falls.
- Forward – Forward contracts are contracts through which two parties agree to buy or sell asset at predetermined price. Forward contracts are quite similar to future contract however forward market is non- standardized and non- regulated and therefore the counter-party risk is very high and chances of non performance of contract either by buyer or seller is very high.
- Swaps – Under swaps two parties agree to exchange series of payments or cash flows for a fixed period of time. The basic idea behind swap is to exchange risk arising from difference in cash flows arising due to fixed to floating or floating rate of interest. Swaps are of different types like interest rate swap, credit default swap, commodity swap and so on.