Article

Different Types of Derivative Contracts

24 Nov 2016 Nilesh Jain

Derivatives are financial instruments whose value is derived from other underlying assets. There are mainly four types of derivative contracts such as futures, forwards, options & swaps. However, Swaps are complex instruments that are not traded in the Indian stock market.

Four Types of Derivative contracts

Four Types of Derivative Contracts

Futures & Forward contract

Futures are standardized contracts and they are traded on the exchange. On the other hand, Forward contract is an agreement between two parties and it is traded over-the-counter (OTC).

Futures contract does not carry any credit risk because the clearing house acts as counter-party to both parties in the contract. To further reduce the credit exposure, all positions are marked-to-market daily, with margins required to be maintained by all participants all the time. On the other hand, forward contracts do not have such mechanisms in place. This is because forward contracts are settled only at the time of delivery. The credit exposure keeps on increasing since profit or loss is realized only at the time of settlement.

In derivatives market, the lot size is predefined. Therefore, one cannot buy a contract for a single share in futures. This does not hold true in forward markets as these contracts are customized based on an individual’s requirement.

Lastly, future contracts are highly standardized contracts; they are traded in the secondary markets. In the secondary market, participants in the futures can easily buy or sell their contract to another party who is willing to buy it. In the contrast, forwards are unregulated, so there is essentially no secondary market for them.

CHARACTERISTICS FUTURES CONTRACT FORWARDS CONTRACT
Meaning A futures contract is a standardized contract, traded on exchange, to buy or sell underlying instrument at certain date in future, at specified price. A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future.
Structure Standardized contract Customized contract
Counterparty Risk Low High
Contract size Standardized/Fixed Customized/depends on the contract term
Regulation Stock exchange Self regulated
Collateral Initial margin required Not required
Settlement On daily basis On maturity date

Options Contracts

Option is the most important part of derivatives contract. An Option contract gives the right but not an obligation to buy/sell the underlying assets. The buyer of the options pays the premium to buy the right from the seller, who receives the premium with an obligation to sell the underlying assets if the buyer exercises his right. Options can be traded in both OTC market and exchange traded markets. Options can be divided into two types - call and put. We shall explain these types in detail in our next article on Options.

Swaps

A swap is a derivative contract made between two parties to exchange cash flows in the future. Interest rate swaps and currency swaps are the most popular swap contracts, which are traded over the counters between financial institutions. These contracts are not traded on exchanges. Retail investors generally do not trade in swaps.

To summarize, in Derivative contracts, futures & options together are considered to be the best hedging instrument and can be used to speculate the price movement and make maximum profit out of it.

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Different Types of Derivative Contracts

24 Nov 2016 Nilesh Jain

Derivatives are financial instruments whose value is derived from other underlying assets. There are mainly four types of derivative contracts such as futures, forwards, options & swaps. However, Swaps are complex instruments that are not traded in the Indian stock market.

Four Types of Derivative contracts

Four Types of Derivative Contracts

Futures & Forward contract

Futures are standardized contracts and they are traded on the exchange. On the other hand, Forward contract is an agreement between two parties and it is traded over-the-counter (OTC).

Futures contract does not carry any credit risk because the clearing house acts as counter-party to both parties in the contract. To further reduce the credit exposure, all positions are marked-to-market daily, with margins required to be maintained by all participants all the time. On the other hand, forward contracts do not have such mechanisms in place. This is because forward contracts are settled only at the time of delivery. The credit exposure keeps on increasing since profit or loss is realized only at the time of settlement.

In derivatives market, the lot size is predefined. Therefore, one cannot buy a contract for a single share in futures. This does not hold true in forward markets as these contracts are customized based on an individual’s requirement.

Lastly, future contracts are highly standardized contracts; they are traded in the secondary markets. In the secondary market, participants in the futures can easily buy or sell their contract to another party who is willing to buy it. In the contrast, forwards are unregulated, so there is essentially no secondary market for them.

CHARACTERISTICS FUTURES CONTRACT FORWARDS CONTRACT
Meaning A futures contract is a standardized contract, traded on exchange, to buy or sell underlying instrument at certain date in future, at specified price. A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future.
Structure Standardized contract Customized contract
Counterparty Risk Low High
Contract size Standardized/Fixed Customized/depends on the contract term
Regulation Stock exchange Self regulated
Collateral Initial margin required Not required
Settlement On daily basis On maturity date

Options Contracts

Option is the most important part of derivatives contract. An Option contract gives the right but not an obligation to buy/sell the underlying assets. The buyer of the options pays the premium to buy the right from the seller, who receives the premium with an obligation to sell the underlying assets if the buyer exercises his right. Options can be traded in both OTC market and exchange traded markets. Options can be divided into two types - call and put. We shall explain these types in detail in our next article on Options.

Swaps

A swap is a derivative contract made between two parties to exchange cash flows in the future. Interest rate swaps and currency swaps are the most popular swap contracts, which are traded over the counters between financial institutions. These contracts are not traded on exchanges. Retail investors generally do not trade in swaps.

To summarize, in Derivative contracts, futures & options together are considered to be the best hedging instrument and can be used to speculate the price movement and make maximum profit out of it.