Types of Derivatives

Derivative contracts come in different types, each serving a specific purpose. They vary in structure, risk, returns, and payoff. Selecting the right derivative depends on the asset class and the trading or hedging objective.

Forwards Contract

Forward contracts are agreements between a buyer and a seller to buy or sell an underlying asset at a future date for a price fixed today. The transaction will be carried out on the agreed future date regardless of the market price at that time. Forward contracts are not traded on exchanges; they cannot be bought or sold on the BSE or NSE. Instead, they are privately negotiated (over-the-counter) agreements where the parties must directly find a counterparty.

Futures Contract

Futures contracts are standardized agreements to buy or sell an underlying asset at a future date at a price fixed today. Unlike forward contracts, futures are exchange-traded and can be bought or sold on recognized exchanges such as the BSE and NSE. They are similar to forwards in concept, but differ in that they require daily marking-to-market, where profits and losses are settled on a daily basis.

Options

Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time period. The buyer may choose to exercise the option only if it is profitable; otherwise, the contract can be allowed to expire. This limited obligation is what distinguishes options from other derivative instruments.

 
 

Types of Options

CALL OPTION (BUY)

A call option gives the buyer the right, but not the obligation, to buy the underlying asset at a fixed price and profits when the asset’s price rises.

PUT OPTION (SELL)

A put option gives the buyer the right, but not the obligation, to sell the underlying asset at a fixed price. The buyer profits when the price of the asset falls.

Swaps

Swap contracts are complex derivative instruments mainly used by large corporations and financial institutions. In a swap, two parties exchange liabilities or cash flows on agreed terms, and changes in their value result in profit or loss.

Example: Person B initially pays a fixed interest rate. After entering into a swap, they pay a variable rate instead. If interest rates fall, Person B benefits by paying a lower rate; if rates rise, they incur losses. This explains how interest rate swaps work. Swaps are traded over the counter, not on exchanges like BSE or NSE, and are customized to the parties’ needs.

Who are Hedgers

Hedgers are market participants who use derivative instruments mainly to protect themselves from adverse price movements or uncertainty. Their objective is not to make profits from derivatives, but to minimize potential losses arising from unfavorable changes in prices.

For example, a sugar seller would want to safeguard against a fall in sugar prices and therefore uses hedging to protect herself from a significant price decline in the future.

On the other hand, a bakery that regularly purchases sugar as a raw material would want to protect itself from a rise in sugar prices and therefore hedges to lock in costs and avoid higher prices in the future.

With hedging the person is trying to reduce risk and as a result will have to let go of some of the profits that they might have made with out the hedge. Hedgers are not concerned with profitability when it comes to derivatives related transactions.

Who are Speculators

Speculators are market participants who deliberately take on higher risk by using derivative contracts to benefit from expected market movements. Their primary objective is to earn profits by correctly anticipating price changes.

 
 

Most traders fall in this category. They are not looking for hedges for their main portfolio. They are activity looking to earn using their trading strategies.

Who are Arbitrageurs

Arbitrageurs are participants who closely monitor markets for price differences in the same asset across different markets or instruments. They seek to profit from these market inefficiencies, though such arbitrage opportunities are generally rare and short-lived.

For Example: Let us say the price of 1 kg cabbages in your market A is Rs 100.

And the price of the same 1 kg cabbages in your friend’s area market B is Rs 80

Here as an Arbitrageur, you may see an opportunity to buy from Market B and sell in Market A at a profit of Rs 20 per kg.

HEDGING

  1. Only for Safety
  2. Objective to reduce overall portfolio risks
  3. Lowers potential profit. Reduces overall portfolio profitability due to the cost of hedging.

SPECULATION

  1. Only for Profit
  2. Doesn’t account for risk. Open to Higher risks.
  3. Higher risk and profit potential. Higher potential for losses too.
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