Types of Financial Derivatives

Basically following financial derivative are available for trading in India:

1) Forwards: A forward contract is a simple customized contract between the two parties to buy or sell an asset on a certain date in the future for a certain price.

Unlike future contracts, they are not traded on an exchange, rather traded in the over-the-counter market, usually between two financial institutions or between a financial institution and one of its components (subsidiary companies).

In other words, it is a privately negotiated contract that is not traded in an organized marketplace or exchange. Both parties to a forward contract are required to follow the terms and conditions mentioned in the contract.

The terms and conditions of the contract specify the quantity, quality, and delivery periods. Both parties are expecting to make or receive delivery of the commodity on the agreed date. It is difficult to get out of a forward contract unless both parties are mutually agreed upon.

2) Futures: A futures contract is an agreement between two parties to buy or sell an asset on a certain date with specified quantity, quality, and price in the future. Futures contracts are different from forwarding contracts in various aspects as the former are traded in standardized exchange, and the latter are traded in over telephone or telex (OTC).

Unlike forward contracts, the counterparty to a futures contract is the clearing corporation on an appropriate exchange. Futures are often settled in cash or cash equivalents; rather, it is not required to have physical delivery of the underlying asset. Parties to a Futures contract may enjoy exercising their option either to buy or write options on futures.

3) Options: Options are the derivative contract that gives the right but not the obligation to either buy or sell specific underlying security for a specified price (called as strike/exercise price) on or before a specific date.

The option contracts are created for any type of underlying security. Equity (stock) is the most common underlying asset, but there are several other categories of non-equity options on the basis of the underlying assets, such as bonds, foreign currency, indices, or commodities, like gold or oil.

The person who buys underlying assets through an option contract is normally known as the buyer or holder. Conversely, the seller is known as the seller or writer.

4) Swaps: A swap is a derivative contract that is formed to exchange the contract’s underlying asset in the future for a specified date. Where one asset is exchanged for another or one liability is exchanged for another or more specifically, one stream of cash flows is exchanged for another.

A swap is a private contract between two parties in which both parties are obligated to exchange some specified cash flows at periodic intervals for a fixed period of time. Unlike a forward or a futures contract, a swap contract generally involves multiple future points of exchange.

The common financial derivatives can be depicted in the table given below.

Common Financial Derivatives

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