Different Types of Derivative Contracts

Nilesh Jain

24 Nov 2016

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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Why to Choose Mutual Funds Instead of Directly Investing Into Equities?

Whether to invest in equities or mutual funds is a question that has plagued every investor. As someone who needs the best value for his/her investment should you invest in equity directly or via mutual funds?

Let’s start by first understanding what these two terms ‘equities’ and ‘mutual funds’ stand for-

Equities- Equities generally represent ownership of a company. If you own any equity in a company, you are a part owner of the said company (depending on how much equity you own).

Mutual Funds – It is an investment scheme which is professionally managed by an asset management company. It pools together the resources of a group of people and invests their money in equities, debentures, bonds and other securities.

Why choose mutual funds over equities?

For people who’ve never invested in either stocks or mutual funds, it is hard to know which is better and where to start. Broadly speaking, if you are a novice investor, mutual funds are not only less risky but also way easier to manage. Here are some ways in which investing in mutual funds is beneficial as opposed to investing in equities -

Diversification

Mutual funds provide more diversification as compared to an individual equity stock. When you invest in equity, you are investing in a single company which has its inherent risk. For example, if you invest Rs.20,000 in buying equities of one company, you could face a total loss if that particular company performs poorly in the market.  

If you invest the same amount in mutual funds, it will be invested in different kinds of stocks and financial instruments, high-risk and low-risk both, so you might not face total loss even if one company does poorly.

Scale of Investment and Lower Costs

For an individual investor buying and selling stocks is a difficult task due to its high price. Thus, any gains made from stock appreciation are nullified if the overall trading costs are considered. Comparatively with mutual funds, as the money is pooled from a large number of investors, the cost per individual is lowered.  

Another advantage of mutual funds is that you don’t need to invest large sums of money. Buying equities for a profitable venture needs huge amounts of money, a minimum of few lakhs. With mutual funds, you can start with Rs.1000 and earn profits on that as well.

Convenience

Keeping an eye on the markets everyday is a time-consuming business, especially if you are investing as a side gig. There are people who spend their lives studying the market and still end up sustaining heavy losses. Though investing in mutual funds does not guarantee high returns, it is stress-free and needs less work as compared to investing in equities.

To sum it up

It is important to remember that mutual funds have their own disadvantages as well. Thus, as with any financial decision, educating yourself and understanding the suitability of all the available options is the ideal way to invest. 


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Different Types of Derivative Contracts

Nilesh Jain

24 Nov 2016

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.

Have Referral Code?