A Derivative contact is a contract between two parties that derives its value from the value of another asset – known as the underlying. Thus, the value of the derivative contract is linked to the value of the underlying asset.
Common underlying assets include stocks, bonds, indices (eg NIFTY), currencies or commodities like gold, silver, oil or even spices.
The following are the most common forms of derivative contracts:
Forward Contracts:
We can define a forward contract as an agreement between two parties to exchange a specific asset on a specified future date at a predetermined price (forward price). Both the delivery and the payment is made on the specified future date.
Thus, if I enter into a contract with Mr B on 1st of January 202X, to buy from him 1000 Kilos of Sugar at the price of 1 doller per Kg; and the exchange (of money and sugar) is to happen on 1st of October 202X, I have effectively entered into a forward contract.
Now, on the contract settlement date i.e on 01st October 202X, if the market price of sugar is 1.20 doller per Kg, I stand to gain as I can buy 1000 Kgs of sugar at 1 doller per Kg and then immediately sell then in the market at 1.20 doller per kg.
However, if on the contract settlement date if the market price of sugar is 0.80 doller per Kg, I stand to lose as I am obliged to buy 1000 kgs of sugar from Mr B at 1 doller per kg while the market price is a lot lower than that.
Futures Contract:
Futures contracts are similar to forward contracts in the sense that these too are agreements to exchange a specific asset on a specified future date at a pre-determined price.
However, there are structural differences between the two.
Futures, are exchange traded standardised contracts. So, while in case of a forward contract, you are open to negotiate the quantity of the underlying asset to be exchanged with the counter-party to the contract, in case of a futures contract, it is the exchange which determines the ‘quantity’ of the asset underlying the contract. This is known as “lot size” in financial parlance.
A exchange is a regulated marketplace for buying or selling securities. Since futures are traded on stock exchanges, they carry negligible counter party risk. Counter party risk is the risk that the other party to the contract will default on his or her obligation(s). Here, it is the exchange which guarantees that both the parties would honour the contract on the settlement date.
Also, futures contracts are net settled. This means that the parties to the contract will NOT exchange the actual underlying asset but the difference between the ‘pre-determined’ price and the market price of the underlying lot of assets on the contract settlement date.
Option Contracts:
Option contracts or simply ‘options’ are derivative contracts that give you the option (a right but not an obligation) to buy/sell a particular asset/security or a ‘lot’ of assets/securities at a pre-determined price.
Similar to futures, options are also exchange-traded standardised contracts.
Option contracts give you the right but not the obligation to buy/sell a given lot of assets/securities at a pre-determined price. So on or before the contract settlement date you have the option to opt out of the contract.
However, this convenience comes at a price and all option contracts require an upfront payment known as the option premium. This premium is payable by the buyer of the option contract to the option writer (i.e the counter-party to your option contract).
Options contracts are generally of two types: Call Options and Put Options.
When you buy a Call Option, it give you the right but not the obligation to buy a pre-determined lot of assets/securities at a pre-determined price on/before the contract expiry date.
Similarly, when you buy a Put Options, it give you the right but not the obligation to sell a pre-determined lot of assets/securities at a pre-determined price on/before the contract expiry date.
Swap Contract:
A swap contract is a contract between two parties to exchange cashflows. Swap contracts are typically over-the-counter financial products with banks or financial institutions often acting as intermediaries to the parties to the contract.
The following are the most common forms of swap contracts:
a) Interest Rate Swap: An interest rate swap is a derivative contract between two parties to swap or exchange cashflows represented by a fixed rate of interest on a ‘notional’ principal amount for a floating interest rate.
b) Currency Swap: In its simplest form, a currency swap is a contract to swap cashflows designated in two different currencies at a future date. This virtually locks in the exchange rate between two currencies at a future date and helps individuals/firms hedge against exchange rate risks.
Uses of Derivative Contracts:
Typically derivative contracts are used to hedge risks associated with any adverse movement in prices of assets or exchange rates.
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