Several people invest their hard-earned money in the stock market by taking risks and thinking of making good returns. But they don't know that investing in the stock market can turn out to be a riskier one due to changes in the price of securities like currency, equity, commodities, etc.
During such times you may lose out all your money, and this can wipe out all your entire investments within a fraction of seconds.
Several instruments can protect you from the volatility of financial markets and turned out to be useful ones.
Not only do these instruments protect the traders from risk, but they also deliver guarantees to them. These instruments are called Derivatives.
So, this article will provide in-depth information about the concept of derivatives and different types of financial derivatives in detail.
Before diving into types of derivatives in India, let us understand the meaning of derivatives first.
It means financial contracts that earn their value from a group of assets or underlying assets are called derivatives. Depending on the market conditions, the value of derivatives keeps on changing.
The primary principle of entering into derivative contracts is to earn a large amount of profits by contemplating the underlying asset's value in the future.
Imagine you've invested in an equity share and the market price of that equity share fluctuates up and down continuously. If the market falls, you may suffer a loss due to a stock value downfall.
In this type of situation, you may enter into a derivative contract, either make to profit by placing an exact bet, or simply take a rest from yourself from the losses that occurred in the stock market where the stock is being traded.
There are four different types of derivatives that can easily be traded in the Indian Stock Market. Each derivative is different from the other and consist of varying contract conditions, risk factor and more.
The four different types of derivatives are as follows:
Let us have a look and study in-depth detail about these derivatives.
Forward contracts mean two parties come together and enter into an agreement to buy and sell an underlying asset set at a fixed date and agreed on a price in the future.
In simpler words, it is an agreement formed between both parties to sell their asset on an agreed future date.
The forward contracts are customized and have a high tendency of counterparty risk. Since it is a customized contract, the size of the agreement entirely depends on the term of the contract.
Forward contracts do not require any collateral as they are self-regulated. The settlement of the forward contract gets done on the maturity date, and hence they are reserved by the expiry period.
Future contracts are similar to forward contracts. Future contracts mean an agreement made by the two parties to buy or sell an underlying instrument at a fixed price on a future date.
Future contracts do not allow the buyer and seller to meet and enter into an agreement. In fact, the deal gets fixed through exchange mode.
In futures contracts, the counterparty risk is low because it is a standardized contract. In addition, the clearinghouse plays the role of a counterparty to the parties of the contract, which reduces the credit risk in the future.
The size of future contracts is fixed, and it is regulated by the stock exchange just because it is known as a standardized contract.
Since these contracts are standard, the futures contracts listed on the stock exchange cannot be changed or modified in any possible way.
In simpler words, future contracts have pre-decided size, pre-decided expiry period, pre-decided size. In futures contracts, an initial margin is required because settlement and collateral are done daily.
Options contracts are the third type of derivative contracts in India. Options contracts are way different than future and format contracts because these contracts do not require any compulsion to discharge the contract on a specific date.
Options contracts provide the right but not the commitment to buy or sell an underlying instrument.
Option contracts consist of two options:
Incall option, the buyer has all the right to purchase an underlying asset at a fixed price while entering the contracts. While input option, the buyer has all the right but not obligation to sell an underlying asset at a fixed price while entering the contract.
However, in both call and put option contracts, the buyer chooses to settle all the contracts on or before the expiry period.
Thus, anyone who regularly trades in the option contract can take any of the four different positions, i.e., short or long, either in the call or the put option. These options are traded at the stock exchange and over the counter market.
Out of all three derivatives contracts, swap contracts are one of the most complex contracts.
Swap contracts mean the agreement is done privately between both parties. The parties who enter into swap contracts agree to exchange their cash flow in the future as per the pre-determined formula.
Under swap contracts, the underlying security is the interest rate or currency, as these contracts protect both parties from several major risks.
These contracts are not traded to the Stock Exchange as investment banker plays the role of a middleman between these contracts.
It means financial contracts that earn their value from a group of assets or underlying assets are called derivatives
The four different types of derivatives in India are as follows:
1) Forward Contracts
2) Future Contracts
3) Options Contracts
4) Swap Contracts
Options contracts are way different than future and format contracts because these contracts do not require any compulsion to discharge the contract on a specific date.
The agreement in swap contracts is privately done between both parties. The parties who enter into swap contracts agree to exchange their cash flow in the future as per the pre-determined formula because the investment banker plays the role of a middleman between these contracts.
Forward contracts mean two parties come together and enter into an agreement to buy and sell an underlying asset set at a fixed date and agreed on a price in the future.
Final Thoughts
Derivative contracts like future, forward options are one of the best contracts to earn profit. The traders can analyze and predict the future price movement of their equity share and accumulate huge profits out of these contracts.