Different Types of Derivative Contracts

The different types of derivative contracts are as follows:

1. Options: One of the common forms of derivatives is the Options contract. These are the financial contracts where the buyer or seller has the right to either buy or sell an underlying asset but not the obligation to do so. Options and futures are quite similar except for the obligation factor. Here, the two parties (buyer or holder and seller or writer) deal a contract to trade an underlying asset at a predetermined price for a future date. The parties are under no obligation to exercise the contract, i.e., they can either exercise their right or else leave the contract before the expiry date. Two types of options are available: Call and Put option.

2. Futures: Futures derivative contracts are standardized agreements to trade an underlying asset at a predetermined price on a specified future date. Here, parties exercise their contract with the help of a third party (exchanges). Some common underlying assets include commodities, financial instruments, and stock indices.

3. Forwards: Forward derivative contracts are similar to the futures contracts. The only difference is that forwards are customizable contracts between two parties to trade an underlying asset at an agreed-upon future date and price. They are exercised over-the-counter (OTC) and are more tailored to the needs of both the parties involved.

4. Swaps: Another form of derivative is the swap contract. It involves the exchange of cash flows or any other financial instruments among two parties (buyer or seller). Some of the common types of swaps include interest rate swaps (fixed-rate and floating-rate interest are exchanged), currency swaps (cash flows in different currencies are exchanged), and commodity swaps (cash flows based on commodity prices are exchanged).

5. Warrants: These are different forms of derivative options that are issued by an enterprise. Here, the holder (buyer) is given the right to buy the shares of the company at a predetermined price for a specified period. They are often used as incentives or sweeteners in securities offerings.

Derivatives are a form of special financial instrument where the value of these instruments is derived from an underlying asset or an index. As the name goes, derivatives are linked to some form of financial instrument, indicator, or commodity. Some commonly used assets include stocks, bonds, commodities, currencies, and market indices. Initially, these underlying assets are created using any individual security or a combination of securities. As the value of these securities changes, the value of the derivatives also keeps changing. Derivatives are those complex instruments used in trading risk in the financial markets by either hedging, speculating, or arbitraging. Derivatives form the basic concept under consideration in financial engineering. The primary purpose of derivative contracts is to generate profit by speculating the future value of the underlying asset.

Geeky Takeaways:

• Derivatives are financial contracts where the value is determined based on the underlying stocks, bonds, commodities, or certain market indices. In simple words, predicting and agreeing to a future value of an underlying asset.
• These financial contracts are used by hedgers, speculators, arbitrageurs, and margin traders for risk management, hedging, speculation, and arbitrage among different markets.
• Derivatives are traded in two platforms either via over-the-counter (OTC) trading or via a standardized exchange.
• These contracts can take either simple or complicated forms of options, futures, forwards, swaps, or warrants.