Broadly derivatives can be classified into below categories:
1) On the Basis of Underlying Assets: Underlying asset is a term used in derivatives trading, such as with options. A derivative is a financial instrument whose price is based (derived) from a different asset. The underlying asset is the financial instrument (e.g., stock, futures, commodity, currency, index) on which a derivative’s price is based.
- Equity Derivative: An equity derivative is a derivative instrument with underlying assets based on equity securities. An equity derivative’s value will fluctuate with changes in its underlying asset’s equity, which is usually measured by the share price. Options are the most common equity derivatives because they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds, or stock index futures.
Examples of equity derivatives are:
- Warrants: A warrant, like a call option, is a right to buy a share of a specified company at a certain price during a given time period. While an individual issues the call option, the warrant is issued by the company, and its proceeds are part of equity. If a warrant is exercised, it increases the company’s number of shares and thus dilutes the equities of its shareholders.
- Convertible Bonds: Convertible bonds mean that these variants are convertible into equity shares. Some of the convertible bonds have detachable warrants involving acquisition rights. In other cases, there is automatic convertibility into a specified number of shares. Convertible bonds command a comparatively high market value because of the convertibility privilege. The value is the sum of the naked value existing in the absence of conversion and the conversion value.
- Interest Rate Derivatives: An interest rate future (IRF) is a financial derivative with an interest-bearing instrument as the underlying asset. Interest rate futures means a standardized interest rate derivative contract traded on a recognized stock exchange to buy or sell notional security or any other interest-bearing instrument or an index of such instruments or interest rates at a specified future date, at a price determined at the time of contract. Interest rate futures are relatively new financial statements. It is one of the most successful financial futures instruments in the world. Interest rate futures trade in several maturities, currencies, and different markets such as mortgages, federal issuance, and short-term commercial paper. Examples of Interest rate futures are Treasury-bill futures, Treasure-bond futures, and Euro-Dollar futures.
- Foreign Exchange Derivative: Any financial instrument that locks in a future foreign exchange rate. These can be used by currency or forex traders, as well as large multinational corporations. The latter often uses these products when they expect to receive large amounts of money in the future but want to hedge their exposure to currency exchange risk. Financial instruments that fall into this category include currency options contracts, currency swaps, forward contracts, and futures contracts.
- Commodity Derivatives: In the case of commodity derivatives, underlying assets can be commodities like wheat, gold, silver, etc. Whereas financial derivatives underlying assets are stocks, currencies, bonds and other interest rates bearing securities, etc. Thus, futures, options, or swaps on gold, sugar, jute, pepper, etc. are commodity derivatives.
- Credit Derivative: Are structured based on credit instruments or loans where the pay off is decided based on a credit event. These contracts are linked to a third party reference asset. Credit default swaps, credit default options, collateralized bond obligations, etc., are examples of credit derivatives.
2) On the Basis of Financial Derivative Trading in India:
- Forwards: Forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made.
- Futures: It denotes a legal contract which enumerates an agreement for the purchase or sale of a specific quantity of foreign exchange at a future date at a specific time on a specific stock exchange. The specific future date is known as the settlement date or delivery date. The current price is also known as the future price.
- Options: An option buyer acquires the right to buy or sell a specified amount of currency for another currency at a specific rate. The date of the transaction is also determined in advance. The buyer of the option is under no obligation actually to carry out the transaction. The person has the right to decide so. Options exist in two variants; call option and put option.
- Swaps: Under this type of transaction, the financial intermediaries are responsible for buying and selling a specific foreign currency for different maturity dates. The swapping process leads to simultaneous purchase and selling of the same foreign currency for different maturity dates. The value of the contracts is kept the same. This is done to manage risk. The process may also be used for arbitrage purposes. This is the practice that involves exploiting price differential occurring in two or more different markets.
3) On the Basis of Market in which they Trade: It includes:
- Exchange-Traded Derivative Market: As the word suggests, derivatives that trade on an exchange are called exchange-traded derivatives. In the Exchange Traded Derivatives Market exchange acts as the main party, and by the trading of derivatives actually risk is traded between two parties. One party who purchases a futures contract is said to go “long,” and the person who sells the futures contract is said to go “short.” Exchange-traded is standardized contracts with predetermined exercise prices and standard expiration months (March. June, September, and December). The principal centers are the Philadelphia Stock Exchange and Mercantile Exchange, Chicago. Access to the market is through brokers who impose commissions for each contract traded. The market operates on the exchange floor, where the brokers gather to reflect their client’s orders with market makers. The markets have specified opening and closing times for each currency market.
The exchange-traded derivatives market has the following features:
- An electronic exchange mechanism and emphasis’s anonymous trading,
- Full transparency,
- Use of computers for order matching,
- Centralization of order flow,
- Price-time priority for order matching,
- Large investor base,
- Wide geographical access,
- Lower costs of intermediation,
- Settlement guarantee,
- Better risk management, and
- Enhanced regulatory discipline, etc.
- OTC Derivatives Markets: A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase “over-the-counter” can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. The dealer act to bring the counterparties together but have no part in the transaction itself. A fee is levied on both counterparties by the broker for such deals. Trades concluded directly are commission fees. In general, the reason for which a stock is traded over-the-counter is usually that the company is small, making it unable to meet exchange listing requirements. Also known as “unlisted stock,” these securities are traded by broker-dealers who negotiate ‘ directly with one another over computer networks and by phone. L The main participants of the OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks market the derivatives through traders to clients like hedge funds and the rest.
The OTC derivatives markets have the following features | compared to exchange-traded derivatives:
- The management of counter-party (credit) risk is decentralized and located within individual institutions;
- There are no formal centralized limits on individual positions, leverage, or margining;
- There are no formal rules for risk and burden-sharing;
- There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants; and
- The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision, and market surveillance.
4) On the Basis of Complexity: It includes:
- Hybrid/Exotic/Sophisticated Derivatives: Exotic derivatives are a specific type of financial asset. These are derivatives (assets whose value depends on another underlying asset) that do not have a standard pay-off, as is the case for a regular call option. It refers to any derivative security, which is not European or American vanilla call or put on a single underlying security. These options are more complex than options that trade on an exchange and generally trade over the counter. For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the option is a put or call at a certain point during the option’s life. Because this x type of option can change over the holding period, it is apparent that this type of option would not be found on a regular exchange. That is why it is classified as an exotic option.
Other types of exotic options include:
- Barrier options,
- Asian options,
- Digital options, and
- Compound options.
- Weather Derivatives: Weather Derivatives are financial products that enable an organization to offset the financial risk due to a weather variable. They allow companies to control the effects of weather on demand for their products. This hedging reduces the volatility of future revenue to more predictable cash flow. A degree-day is the deviation of a day’s average temperature form the reference temperature. This was found to be a useful measure that the energy suppliers could use to hedge their supply in adverse temperature conditions. The common forms of weather derivatives are call options, put options, caps, floors, collars, and swaps. Some exotic varieties like one-touch, digitals, barrier, and basket options are also structural to meet the specific needs.