Chapter 2 Types Of Derivatives

Forward contract

A forwards contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. Since forward contracts are not traded on a centralized exchange, they are regarded as over the counter instruments, which also give rise to counter party default risks. A forward contract settlement can occur in cash or on delivery basis. Since forward contracts are non-standardized, it is of interest to those who wish to hedge by customizing the contract to any commodity, amount or delivery date.

Futures contract

This is a standardized contract between two parties to buy or sell an asset at a specified time in the future at a specified price. Futures are standardized exchange traded contracts. Futures’ trading is of interest to those who wish to:

• Speculate by taking a view on the market and buying or selling accordingly

• Prefer Price Risk Transfer through hedging

• Take advantage of the leverage offered by paying a small fraction of the total contract as margin

Options

There are two basic types of Options - Call and Put. Call Option gives the buyer the right but not the obligation to buy a specified amount of an underlying security at a specified price within a specified time. On the other hand, a Put Option gives the buyer the right, but not the obligations to sell a specified amount of an underlying security at a specified price within a specified time. Option trading is of interest to those who wish to:

• Participate in the market without trading or holding a large quantity of stock

• Protect their portfolio by paying small premium amount

Future and Option Products Available in Indian Markets

Futures and Options contracts are traded on indices and on individual stocks. Popular indices products available on the Indian stock exchanges are Nifty 50, CNX IT Index, Bank Nifty Index, CNX Nifty Junior, CNX 100, Nifty Midcap 50, Mini Nifty and Long dated Options contracts on Nifty 50.

Key Takeaways

• Forwards are customized contracts which can lead to counter party default.

• Futures were introduced to eliminate counter party default by standardizing the contract.

• Options are of two types - call and put.