Understanding Derivatives and its Types
16 January, 2024
What are financial derivatives?
Financial derivatives are securities / instruments that do not possess any value of their own but derive their value from an underlying security.
They are more commonly used for hedging purposes, i.e. mitigating / reducing the overall risk. Financial derivatives are also used to make gains via speculation of supply and demand.
Derivatives are traded on stock exchanges like NSE, BSE, etc. and the over-the-counter (OTC) market.
Types of derivative contracts
Futures contracts
They are standardised agreements between two parties, used for transacting (purchase or sale) an underlying asset at a mutually agreed price on the specified date of the contract. Futures contracts are traded on the exchange and hence, are standardised. Futures contracts exhibit a set lot size and a predetermined expiration date.
The credit risk with such contracts is minimal as they are settled by the clearing houses, which act as a counterparty on both legs of the transaction. A futures contract can be of any underlying asset, like equities, commodities, foreign exchange, etc.
Some of the most common future contracts you might have already heard of include Nifty Futures, Bank Nifty Futures, etc. The NSE governs these contracts and establishes all trading conditions. For instance, Nifty Futures currently possess a lot size of 50 units as stipulated by the NSE. Each futures contract reaches its expiration at the conclusion of its corresponding month.
Forwards contracts
A forwards agreement is similar to a futures contract in essence but is categorically different on the basis on which forwards contracts are traded.
Forwards contracts are traded on the OTC market, and the terms of the agreement are customisable.
Unlike a futures contract, a forwards agreement is not restricted by any pre-defined lot size and is tradable in any quantity where both counterparties can mutually agree. Even the settlement or expiry date of such contracts can be on the need basis of both parties.
Since no clearing house is involved in such agreements, the credit risk of counterparty settlement is higher than that of a futures contract.
Retail investors or traders typically do not engage in trading forward contracts; instead, these contracts are more commonly utilised by corporations operating within financial markets.
Swaps
A swap is a derivative contract that enables the exchange of future cash flows between the two parties engaged in the agreement. Swaps are used for safeguarding against the risk of credit default via a Credit Default Swap (CDS).
The most commonly used swap agreements are Interest Rate Swaps (IRS) and Foreign Exchange Swaps (FX Swaps). They are traded on the OTC market and are usually not dealt with by retail traders / investors.
Options contracts
An option contract gives the parties involved a right but not an obligation to buy / sell the underlying assets at a predetermined date in the future for a specified price. The most crucial element of this agreement is that it only gives you the right to conduct a transaction but does not make it necessary for you to indulge in it.
The buyer of an options contract pays the associated premium (the price at which the option is trading), and gets the right to buy the underlying security from the seller, who will be obligated to sell the security, provided the buyer exercises their right.
Options are widely traded on exchanges and in the OTC market. They are used for both hedging and speculation purposes and are available in two types.
Call option: The call option gives the buyer the right to buy the underlying security from the seller at a predefined price on the date of settlement / expiry. Traders usually buy call options when they expect the underlying security's price to rise in the future or to hedge against such an increase in prices.
Put option: This options contract gives the buyer the right to sell the underlying asset at a predefined price on the maturity date of such a contract. Traders usually buy put options when they expect the underlying security's price to decline in the future or to hedge against such a decrease in prices.
Factors that influence the price of an options contract
Price of the underlying asset - Like all derivatives contracts, the underlying asset's price, in comparison to the strike / exercise price of the option, is the most significant factor in the pricing of an options contract. In the case of call options, if the underlying asset's price is above the strike price, then the price of such an options contract will typically tend to increase, and vice-versa in the case of a put contract.
Time - The price element distinguishes option contracts from the rest of the derivatives. The time left until the expiration of the contracts has a significant impact on the prices / premium of the option. The greater the amount of time remaining, the higher the price of an option contract. As and when you move closer to the expiry date, the pricing of the options contract will usually begin to fall, assuming other variables as constant.
Volatility - In scenarios where the underlying asset's price displays volatility, the pricing of its associated options contracts tend to be higher. It is because the likelihood of attaining the desired underlying price is higher compared to a stable market environment.
Interest rates - The interest rate is used for discounting the future cash flows of the option back to the present value. Hence, it fluctuates the price of an options contract.
Conclusion
Derivatives are a powerful financial instrument, which if devised properly, can help you not only hedge your portfolio but also scale up your returns.
To use derivatives in your favour, you need a suitable Demat Account. This is where the HDFC Bank Demat Account can help you. It allows you to not only transact in equities but also derivatives and other products.
But, as with any other security, derivatives are also subject to market risk, and you should indulge in them only after acquiring proper knowledge.
Click here to get started.
*Terms and conditions apply. 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.
