4 Types of Derivative Contracts | Differences, and Characteristics. Derivatives are products whose value is derived from one or more basic variables called underlying assets or base. In simpler form, derivative are financial security such as an option or future whose value is derived in part from the value and characteristics of another an underlying asset. The primary objectives of any investor are to bring an element of certainty to returns and minimize risks.
Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customized as per the needs of the user by negotiating with the other party involved. Such derivatives are called over-the-counter (OTC) derivatives.
A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options, and Swaps.
However, these variations can all be traced back to one of the four categories. These four categories are what we call the 4 basic types of derivative contracts.
Type 1: Forward Contracts
Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.
However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favorable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.
Type 2: Futures Contracts
A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of the commodity at a future date but at a price which is decided in the present.
However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.
An important point that needs to be mentioned is that in the case of a futures contract, they buyer and seller do not enter into an agreement with one another. Rather both of them enter into an agreement with the exchange.
The difference between Forwards Contracts and Futures Contracts?
|1||Nature||Traded on organized exchange||Over the Counter|
|3||Liquidity||More liquid||Less liquid|
|4||Margin Payments||Requires margin payments||Not required|
|5||Settlement||Follows daily settlement||At the end of the period.|
|6||Squaring off||Can be reversed with any member of the Exchange.||Contract can be reversed only with the same counter-party with whom it was entered into.|
Characteristics Futures Contract Forwards Contract
|Charecteristics||Futures Contract||Forwards Contract|
|Meaning||A futures contract is a standardized contract, traded on the exchange, to buy or sell the underlying instrument at a certain date in future, at a specified price.||A forward contract is an agreement between two parties to buy or sell underlying assets at a specified date, at agreed rate in future.|
|Structure||Standardized contract||Customized contract|
|Contract size||Standardized/Fixed||Customized/depends on the contract term|
|Collateral||Initial margin required||Not required|
|Settlement||On daily basis||On maturity date|
Type 3 : Option Contracts
An option is a financial instrument that gives the holder the right to engage in a future transaction on an underlying security or futures contract. The holder is under no obligation to exercise this right. There are two main types of option. A call option gives the holder the right to purchase a specified quantity of a security at a fixed price (the strike price) on or before the specified expiration date. A put option gives the holder the right to sell. If the holder chooses to exercise the option, the party who sold, or wrote, the option is obliged to fulfill the terms of the contract.
Since forward and futures trading obligates both buyer and seller to fulfill their contracts, the third form of derivatives is introduced that provides a right to one party and obligation to the other party. Options trading are a contract that gives a right without obligation to the buyer, while the seller has an obligation if requested by the buyer to buy or sell a specified security at specified price and time.
Type 4: 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.
SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House to ensure that Derivative Exchange/Segment and Clearing Corporation/House provide a transparent trading environment, safety, and integrity and provide facilities for redressal of investor grievances. Some of the important eligibility conditions are:
- Derivative trading to take place through an on-line screen based Trading System.
- The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real-time basis so as to deter market manipulation.
- The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real-time basis through at least two information vending networks, which are easily accessible to investors across the country.
- The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country.
- The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
- The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
- The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.
- The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
- The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position.
- The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99 percent of the days.
- The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.
- In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close out all open positions.
- The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients’ margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
- The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange/Segment.
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