Importance and Types of Derivatives

A derivative instrument is a contract between two parties which states certain conditions (specifically the dates, the final values of the underlying variables and the notional amounts) under which payments are to take place between the parties. According to the US law and laws in many other developed countries, derivatives possess special legal exemptions that render them a particularly attractive legal form for extending credit.

Derivatives are commonly used among investors for their following usage:

  • Derivative offers leverage (or gearing) in a way that even a slight movement in the value of underlying asset would lead to a large difference in the value of the derivatives.
  • It enables speculating and making a profit if the value of the underlying asset shifts in the way it has been expected (for example shifts in a given direction, remains in or out of a specified range or reaches a certain level).
  • Derivatives instrument facilitates hedging or mitigating risk in the underlying by entering a derivative contract whose value moves in the opposite direction to that of their underlying position and cancels out all or part of it.
  • It enables obtaining exposure to the underlying asset when trading in the underlying asset is a plausible option (for example weather derivative)
  • It also facilitates in creating option ability where the value of the derivative is associated with a specific condition or event (for instance, the underlying value reaching a specific price level).

The derivatives instruments can be broadly be classified into two groups based on the way they are traded in the market. These are:

  • Over the Counter (OTC) derivative: In this type, the derivative instruments are traded between two parties directly, without any intermediary or an exchange. Products which are almost always traded in this way encompass swaps, forward rate agreements, exotic options and exotic derivatives. The OTC derivative market is the largest market for derivatives and is mainly unregulated with regards to disclosure of information between the parties as the OTC market is composed of banks and other highly sophisticated parties such as hedge funds.
  • Exchange traded derivatives: These are derivative instruments that are traded through a specialized derivative exchange or other exchanges. A derivative market is a place where individual trade standardised contracts that have been defined by the exchange. It acts as an intermediary to all the related transactions and receives the initial margin from both sides of the trade to act as a guarantee.

Apart from the above classification, derivatives can be classified into the following types:

  • Forward: Forwards are tailored contract between two parties where payment is undertaken at a specific time in future at today’s pre-determined prices.
  • Futures: Futures are contracts to buy or sell an underlying asset at a specific period at a specified price. It differs from forwards in the aspects that it is a standardised contract written by a clearing house and it operates through an exchange.
  • Options: Options are contracts which give the right and not obligation to buy or sell a specific asset. Call options provides the right to buy whereas the put option provides the right to sell. The price at which the sale takes place is known as the strike price.
  • Binary Options: These contracts provide people with an all-or-nothing profit profile.
  • Warrants: Unlike short term options which mature within a year, these are long term options. These are mostly traded over the counter.
  • Swaps: These are contracts to exchange cash flows on or before a specified date based on the underlying value of the assets. Swaps are commonly classified into currency swaps and interest rate swaps.