What are Derivatives?

Derivatives are primarily financial contracts whose price depends on the underlying asset. Derivatives are also known for being most preferred financial instruments for seasoned investors. There are multiple Derivative products such as Futures, Options, Swaps, and more. All these products come with their sets of advantages and disadvantages. There is untapped potential in Financial Derivative trading in India for long-term investors and savvy short-term speculators.

In this article, let us understand the different types of Derivatives and their advantages and disadvantages.

What should you know about Derivatives?

Derivatives are contracts between multiple parties. The value of this contract depends on an underlying asset or security. Some common underlying assets in the Derivatives market are:

  • Bonds

  • Currencies

  • Interest Rates

  • Commodities

  • Stocks

The most common types of Financial Derivatives available in the market are:

  • Futures Contracts

  • Forward Contracts

  • Interest Swaps

  • Options

Financial Derivative products come under two classes:

  1. Lock Derivatives – This binds the involved parties to the given terms of the contract. If there is a given date for selling or buying the underlying asset, the parties involved will have to adhere to it.

  2. Option Derivatives - This offers the parties involved the choice of selling or buying the underlying asset at a given price before or on the expiration date of the contract.

Most of these Derivatives are traded over the counter. Some specialised Exchanges also allow the trading of Futures and Options through the Demat Account.

What are the different types of Derivatives?

  • Futures Contract:

    Futures are the most traded Derivatives in the market. They allow buying or selling of the underlying asset for parties involved in the trade. The trade takes place at a predetermined price and a pre-set date in the future. However, the value of this Derivative depends completely on the performance of the underlying asset. Future contracts have a specific quantity size and an expiration date, i.e., you cannot purchase only 1 share of XYZ Ltd. if the lot size is 10; each futures contract will involve the purchase of 10 shares on the specified date.

    Let’s say there is a sale on the iPhone 13, and it is being sold at Rs 50,000 instead of Rs 80,000. Now, the problem is that you are still short of money and wish to purchase the iPhone at the discounted price after few months. So, you get into a contract with the seller guaranteeing a purchase at a fixed price of Rs 50,000 on a specific date – called a Futures Contract. The contract price depends on the price of the iPhone, hence it’s a derivative.

  • Forwards Contract:

    Forwards is a more malleable contract as the parties involved can change the quantity of the underlying commodity. Furthermore, unlike Futures Contracts, in Forwards parties get the freedom to change the date of the transaction. These are also not traded over an exchange but over the counter (OTC). Since there is no central governing body here, the terms of the contract can be easily modified and changed.

    A Forwards Contract involves a greater number of people as the seller has the freedom to sell to somebody else if financial requirements are not met – called counterparty risk. So, even if you and ABC Ltd enter a Forwards Contract, it is possible that XYZ Ltd sells it to PQR Ltd and then you and PQR Ltd have a contract, thus increasing the counterparty risk.

  • Options Contract:

    Options Contract is more flexible than Forward and Future Contracts. While its price is dependent on the underlying asset, Options allow the parties involved to buy or sell the underlying asset on maturity or before maturity at the pre-determined price.

    Let’s say you have stocks of XYZ Bank, and you believe that the price will shoot upwards from Rs 800 to Rs 900 in one month. So, you buy a ‘CALL’ Option for one lot, which allows you to buy the shares of XYZ Bank at Rs 800 anytime in the month and sell them at the current price i.e., Rs 900. CALL options are for bullish markets.

    Similarly, if you think the price will tank from Rs 800 to Rs 700, you will go for a PUT option. This allows you to sell the lot at Rs 800 and buy it back at Rs 700 anytime in the one month. PUT options are for bearish markets.

  • Swaps:

    Swaps are contracts that allow the exchange of cash flows or liabilities between two parties. In Swaps, two parties promise to make a series of payments, in exchange for receiving another set of payments from the other party.

    Let’s say Mr X has 5 paintings and Mr Y has 5 cameras. But Mr X wants to do business in cameras and Mr Y wants to do business in paintings. So, they go to a bank which tells them to bring their possessions. The bank takes X’s paintings, keeps 1 for itself, and gives 4 to Y. It takes Y’s cameras, keeps one for itself, and gives 4 to X. Thus, the bank also makes a profit for initiating the swap and connecting businesses.

Swaps can be from two different financial instruments. The two most popular types of Swaps are:

  • Credit Default Swap: In this, the seller is liable to pay the premiums if the borrower defaults on the payment.

  • Interest Rate Swap: Is an agreement between two parties to exchange one stream of interest payments for another, over a set period.

  • Currency Swap: It is an agreement in which two parties exchange the principal amount and the interest of a loan in one currency for the principal and interest of a loan in another currency.

  • Commodity Swap: It is a contract where the involved parties agree to exchange cash flows that are dependent on the price of an underlying commodity.

What are the advantages of Derivatives?

  • Derivatives increase the market efficiency

  • Derivatives help institutes access unavailable assets or markets.

What are the disadvantages of Derivatives?

  • Derivatives are highly volatile, exposing investors to potentially massive losses.

  • Derivatives are highly speculative endeavours. The behaviour of the underlying assets can be unpredictable. 

To learn more about Derivatives or open a Demat Account with HDFC Bank, click here.

Read more about currency derivates here.

*Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. This is an information communication from HDFC Bank and should not be considered as a suggestion for investment. Investments in securities market are subject to market risks, read all the related documents carefully before investing.