An Introduction to Derivatives

Definition:
Derivative is a contract, value of which is derived/ dependent on the value of another asset. This
implies that a derivative contract must be based upon an underlying asset.
The underlying asset can be a physical commodity like gold, wheat, crude oil etc. or a financial
instrument like a stock, bond, interest rate or a market index.

Types of Derivatives
i.

Forward

It is contract between two parties, in which one has the obligation to buy and the other one has the
obligation to sell a specific physical asset or security at a pre-decided price, on a specific date in
future.
ii.

Futures

Futures are like a forward contract with the difference, futures are standardized and exchange
traded. Futures contracts are regulated and backed by a central clearing house of an exchange.
iii.

Swaps

In a swap contract, two parties agree to exchange a series of cash flows on periodic settlement dates
over a certain period of time. Thus a swap contract is also known as a series of forward contracts
that expires on each periodic settlement date.
For example, in simplest swap contract, one party agrees to pay floating interest rate and in return,
receives fixed interest rate on some principal amount from the other party on quarterly basis over a
period of two years. It is called fixed for floating or plain vanilla swap.
iv.

Options

An option is contract that gives its owner the right, not the obligation to buy or sell an underlying
asset at a pre-decided price, on a specific date in future.
An option contract that gives its owner the right to buy is termed as call option.
An option contact that gives its owner the right to sell is termed as put option.

Purpose of Derivatives
Criticism of derivative is that these are complex financial contracts and dealing with them is riskier
than underlying assets so they cause financial loss. This is only the misconception as a derivative
contract itself does not create any additional risk. However, improper handling of such contracts
creates financial losses. Derivatives have following advantages:
i.

Provide Price Information

Derivatives play an important role in determining the present and future prices of underlying asset.
Price of any asset is fluctuated as per rules of demand and supply and derivative market (especially
the futures market which is highly regularized) provides future demand and supply information for a
particular asset. This one can estimate the price of an asset by closely observing its transactions
carried out in derivative market.
For example, a sugar producer does not know what will be sugar price after two months. However,
by closely observing the transactions of futures contracts available on sugar, he can estimate the
demand and supply in future for sugar, can also estimate price of sugar and plan his production
accordingly.
ii.

Help to Manage the Risk

One of the major purposes of derivatives is to manage the risk that is why these are used as hedging
instrument.
Hedging is a strategy used to minimize the investment risk through derivative contract like futures,
options etc.
For example, an investor holds shares of ABC Company which are currently trading at Rs. 200.
Investor estimates a downfall in share price of the company in future. He hedges the risk of this
downfall by entering into a futures contract available for two months for ABC Companys shares at
Rs. 205. Investor gets the obligation of selling share at Rs. 205 according to the current. Now after
two months, if the price of companys shares will decrease up to Rs. 198 as estimated by investor, he
will earn a profit of Rs. 7 per share. Thus investor has reduced / hedged his risk of loss by using
futures contract.
iii.

Reduce the Transaction Costs

Derivatives are helpful in reducing the transaction costs. These are the hedging instruments that are
used to manage the risk. Thus derivatives take a form of insurance and reduce the transaction costs.

For example, a borrower has risk of rising interest rates on loan in near future. If he does not hedge
this risk and interest rates actually rise in near future then borrower will have to bear higher cost
because of paying higher interest rate on his borrowing. However, if borrower has properly hedged
this risk of rising interest rate by using a derivative instrument, he has managed his risk and reduced
the transaction cost.

Classification of Derivatives
A) Derivatives can be classified based on nature of underlying asset into Commodity derivative and
Financial derivative.
i.

Commodity Derivative

This is the type of derivative contract that specifies a physical commodity as underlying asset.
For example, this type of contract may include any precious metal like gold, livestock, oil, grain etc.
as underlying asset.
ii.

Financial derivative

This is the type of derivative contract that specifies a financial instrument as underlying asset.
For example, this type of contract may include financial instruments like stocks, bonds, interest rate, exchange rate,
index etc. as underlying asset.
B) Derivatives can also be classified based upon nature of markets into Exchange-traded
derivative and Over-the-Counter derivative
i. Exchange-Traded Derivative
These types of derivative contracts are regularized by an exchange backed by a clearing house
Futures contracts and options contracts are exchange traded contracts.
ii. Over-The-Counter (OTC) Derivative
These types of contracts are traded in a dealer market that has no central regulatory system.
Forward and swaps contracts are traded in OTC market.

Key Advantages of Exchange Traded Derivative Contracts

i.

Standardization

Derivative exchanges are highly regularized with central location, backed by a clearing house and
have standardized contract terms. Exchange traded derivatives have standardized contract size
means the size is fixed and quantity of underlying assets cant be changed by buyer and seller of the
contract.
ii.

Liquidity

These are highly liquid contracts because managed through a central location by involvement of a
clearing house. Clearing house acts as buyer for seller of the contract and act as seller for the buyer
of the contract. So, finding buyer and seller for exchanged traded derivatives is easier than OTC
market derivatives.
iii.

Elimination of Counterparty Default Risk

Clearing house acts as a counter party (means become buyer for seller of the contract and becomes
seller for the buyer of the contract) for all exchange traded derivative contracts. Thus the risk that
counter party (either buyer or seller) will default by not executing the contract at its expiry date is
eliminated.