Different Types of Derivative Contracts
As financial instruments have existed since ancient times, derivatives as financial instruments were initially used to hedge against price fluctuations of commodities, such as rice and petroleum or precious minerals, such as gold. Products gained popularity in the 1970s following the growing volatility in financial markets and have since represented more than half of all global financial transactions. The derivatives market is broadly defined into Regulated Exchange Derivatives and Over the Counter Derivatives, each presenting various options and benefits represented by multiple types of contracts.
Additional read: How to Manage Risk While Trading in Derivatives
Futures are derivatives contracts in which you agree to the purchase or sell an underlying asset at a given date in the future for a fixed price. You are legally obligated to do so. Futures are standardised contracts in which the parties agree with an exchange, and the arrangements are settled with a clearinghouse. Future contracts have stable margin requirements and do not lose value over time. They offer higher liquidity and easy to understand pricing but are subject to price fluctuations and can devalue significantly as the contract reaches expiration.
Forwards contracts are similar to Futures contracts. Traders agree upon purchasing or selling an asset for a fixed price at a specific date in the future and are legally obligated to do so. However, unlike Futures, Forwards are privately traded in the Over the Counter (OTC) market and are not regulated. Forwards are customisable to the exact specifications of two parties and offer a complete hedge since they cover the period and the size of the exposure and offer price protection.
Options provide buyers with the right but not the obligation to fulfil a contract. Options are of two types: Call Options and Put Options. Call options give the buyer the right to buy the underlying asset in the future at a specific date, but not the obligation to do so. Put Options give the buyer the right to sell the underlying asset in the future at a particular date, but not the obligation to do so. Options require the payment of a deposit by the holder to acquire the right to buy or sell, which is called 'Premium'. An option's exercise depends upon a predetermined price agreed upon while signing a contract, known as the Strike Price. Options can provide higher cost efficiency and allow investors access to complex strategies, such as spreads and combinations, to give them an advantage in market scenarios.
Swaps are bilateral contracts in which the two parties agree to exchange the revenues from two different sources or exchange both the underlying assets and their interests for a while agreed beforehand. The two types of swaps are known as interest swaps and currency swaps. Swap contracts are cheaper, offer longer terms than futures and options, and better match liabilities and revenues for investors and companies.
Between the four types of derivatives, each has its advantages and corresponding disadvantages. You can use them to your benefit, depending upon your financial interests and goals. However, these derivatives more often act as the base for more complex strategies and instruments, such as warrants, leaps and swaptions, which can arise from the careful mix of one or more of these derivatives. Such variations provide flexibility to the derivatives market and its ability to match the needs of its investors, providing stability and integrity to the global economy and trade and impetus to investments in the international market.
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