A derivative is a financial contract which derives its value from one or more underlying assets.
The underlying asset could be stocks, commodities, bonds, currencies, market indexes or interest rates. Derivatives can either be exchange traded or traded over the counter (OTC).
Derivative traded on the exchange are standardised and regulated. On the other hand, OTC derivative constitutes greater proportion of derivatives contracts, but it carries higher counterparty risk and is unregulated.
These financial instruments help in making profit by simply betting on the future value of the underlying asset. Hence the name derivative as they derive the value from the underlying asset.
In a practical sense, derivatives are contracts between two parties with the value of the contract being based on a financial product (stocks, bonds, commodities, interest rates).
Take the scenario below for example:
Suppose you are trading Apple stocks in the US and you strongly believe it is way undervalued. Apple is trading at $470. You could buy the stock, but you need to pay $470 per share, leaving you to play with less a dozen shares in a $5000 portfolio. There is also a theoretical risk of losing all that money if Apple suddenly goes poof.
What if you could get on a bet with someone who thinks Apple is going down, where you get paid depending on the odds? For instance, suppose I have a boatload of Apple stocks bought for the future that I don’t think will go up now. If Apple goes up in the short term, very well. But, I want to protect my case, in case Apple goes down in the short term, due to some Einhorn or Samsung.
Now, we can construct a contract that is similar to the futures contract that benefits both the parties.
The contract could be:
If Apple goes above $490 in the next 1 month, you will get every dollar that is over $490. If Apple doesn’t go above $480, you need to pay $5 to me.
I’m in fact selling a lottery ticket with the strong belief that Apple would not go over $490 in just one month. If it goes that much, I’m anyway profiting a huge way from my boatload of Apple stocks that I don’t mind paying you something. But, if it doesn’t jump that much in a month, your $5 is mine. Actually, I’m kind of renting my stock here.
For you, the advantage is that with just $5 you bought a ticket that could potentially give you huge returns if Apple stock shoots up. For instance, if Apple goes up to $600, you will get $600 minus $480 = $120. This is with just $5 in investment. Mind you, such a probability is low. But, unlike a lottery ticket , this is non-random. If you really have a strong analysis that helps you see that others in the market don’t see, you could reap a windfall of 2400 per cent profit ($120/$5) in 1 month.
Use of derivatives
Derivative contracts like futures and options trades freely on exchanges and can be employed to satisfy variety of needs which includes the following-
•Hedge your securities
The derivative contracts can be used to hedge your securities from price fluctuations. The shares which you posses can be protected on the downside by entering into a derivative contract. Moreover, it also protects you from rise in share price which you plan to purchase.
•Transfer of risk
This is the most important use of derivative which helps in transferring risk from risk averse people to risk seeking investor. The risk seeking investor can enter into a risky contrarian trades to gain short term profits while the risk averse investor can enhance safety of their position by entering into derivative contract.
•Benefit from arbitrage opportunities
Arbitrage trading simply means buying low in one market and selling high in other market. So with the help of derivative contracts, you can take advantage of price differences in two markets. Thus it helps in creating market efficiency.
How to trade in derivative market?
Trading in derivative market is quite similar to trading in cash market with few differences here and there. Let’s understand in detail-
•Conduct a proper research
It is very important to have a full research before entering into the derivative market. However, note that the strategies need to differ from that of stock market. For instance, in cash market, you bought a stock as you expected it rise in future, but in futures market, you may also enter into a sell transaction and hold until expiry unlike cash market. Thus you should make your research accordingly.
•Arrange the margin amount
The derivative contract may require you to maintain the margin amount. So unless and until, your trade is settled, you cannot withdraw this amount from your trading account. Moreover, the margin amount keeps changing with the rise or fall in stock price, thus its always advisable to keep some extra money into your account.
3. Do the required transaction through the trading account
Make sure that your account permits you to trade in derivative contract. If not, contact your broker to activate the required services. You can start trading once this is done.
4. Decide upon the stock you want to trade
Select the stock, the strike price you want to trade and the margin requirement. Based on your cash in hand, plan it properly which suits your budget.
5. Book the profit or loss
You can book the whole amount or can wait until expiry to settle the contract until you get your desired price. If the futures value at expiry is below the strike price, you may suffer
Example 2:
Rob, the CEO of a US -based company is expanding business in Nigeria. He is making revenues in Naira, but has to pay his employees in dollars in the US. Naira is going up and down against the dollar and this is frustrating. Every month he has expenses in dollars and incomes in Naira. One day, Naira is $1 = N370 and on another day $1=N360. When Naira goes down, you get fewer dollars when you convert your Naira to dollars and find it hard to pay your employee salary.
What if you could enter into a stream of futures contracts, where you are entering a contract with a Nigerian CEO with the opposite problem? Now, both of you could set a pre-established rate and trade your revenues for other currency every month. Such a contract is called swaps. This is primarily done between major banks acting on behalf of their clients.
Example 3:
Such a contract is known as call option. You get to bet big on a stock, without risking too much. There are a dozen other types of derivative contracts, but these 3 are the most common ones.
How do you play with the market?
Derivatives are complex instruments. You need to be really comfortable with the stock markets to attempt derivatives. If you are a total newbie to trading, you can get really burnt. Once you are really comfortable with trading, you can start with derivatives.
Have a dedicated time for trading.
This is not buy & hold investing. If you don’t live in the market, you die in the market.
Get a good broker.
Start with options.
Futures are a much more risky game, especially if you don’t understand the dynamics of commodity markets (most futures are commodity futures, although stock index futures are also traded).
Start with buying options (call and put). Never sell options until you are really comfortable with the trading. Eventually you can start hybrid strategies.
Trading isn’t about predicting what happens next. It’s about having a system with an edge.
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losses.
In simple words, buying futures and options is equivalent to simply buying stocks of the underlying company, but without any actual delivery. You can enjoy the same upside or the downside, the way it affects your underlying stocks. Thus, you can trade in the index or stocks, the same way you do in stock market.
Derivatives are financial contracts that derive their value from an underlying asset. These could be stocks, indices, commodities, currencies, exchange rates, or the rate of interest. These financial instruments help you make profits by betting on the future value of the underlying asset. So, their value is derived from that of the underlying asset. This is why they are called ‘Derivatives’.
Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counter party than do standardized derivatives.
Here are four types of derivative contracts – forwards, futures, options and swaps. However, for the time being, let us concentrate on the first three. Swaps are complex instruments that are not available for trade in the stock markets.
Futures and forwards: Futures are contracts that represent an agreement to buy or sell a set of assets at a specified time in the future for a specified amount. Forwards are futures, which are not standardized. They are not traded on a stock exchange.For example, in the derivatives market, you cannot buy a contract for a single share. It is always for a lot of specified shares and expiry date. This does not hold true for forward contracts. They can be tailored to suit your needs.
Options: These contracts are quite similar to futures and forwards. However, there is one key difference. Once you buy an options contract, you are not obligated to hold the terms of the agreement.This means, even if you hold a contract to buy 100 shares by the expiry date, you are not required to. Options contracts are traded on the stock exchange.
Swaps are another common type of derivative. A swap is most often a contract between two parties agreeing to trade loan terms. One might use an interest rate swap in order to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa. If someone with a variable interest rate loan were trying to secure additional financing, a lender might deny him or her a loan because of the uncertain future bearing of the variable interest rates upon the individual’s ability to repay debts, perhaps fearing that the individual will default.
HOW TO TRADE IN DERIVATIVES MARKET:
Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.
First do your research. This is more important for the derivatives market. However, remember that the strategies need to differ from that of the stock market. For example, you may wish you buy stocks that are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market, this would need you to enter into a sell transaction. So the strategy would differ.
Arrange for the requisite margin amount. Stock market rules require you to constantly maintain your margin amount. This means, you cannot withdraw this amount from your trading account at any point in time until the trade is settled. Also remember that the margin amount changes as the price of the underlying stock rises or falls. So, always keep extra money in your account.
Conduct the transaction through your trading account. You will have to first make sure that your account allows you to trade in derivatives. If not, consult your brokerage or stock broker and get the required services activated. Once you do this, you can place an order online or on phone with your broker.
Select your stocks and their contracts on the basis of the amount you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have to pay a small amount to buy the contract. Ensure all this fits your budget.
You can wait until the contract is scheduled to expiry to settle the trade. In such a case, you can pay the whole amount outstanding, or you can enter into an opposing trade. For example, you placed a ‘buy trade’ for Infosys futures at Rs 3,000 a week before expiry. To exit the trade before, you can place a ‘sell trade’ future contract. If this amount is higher than Rs 3,000, you book profits. If not, you will make losses.
Thus, buying stock futures and options contracts is similar to buying shares of the same underlying stock, but without taking delivery of the same. In the case of index futures, the change in the number of index points affects your contract, thus replicating the movement of a stock price. So, you can actually trade in index and stock contracts in just the same way as you would trade in shares.
537 Views · 4 Upvotes
Raah Financials, Financial Services
Answered Jul 28
A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Derivatives can either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterpart than do standardized derivatives.
WHO ARE THE PARTICIPANTS IN DERIVATIVES MARKETS:
On the basis of their trading motives, participants in the derivatives markets can be segregated into four categories – hedgers, speculators, margin traders and arbitrageurs. Let’s take a look at why these participants trade in derivatives and how their motives are driven by their risk profiles.
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Hedgers: Traders, who wish to protect themselves from the risk involved in price movements, participate in the derivatives market. They are called hedgers. This is because they try to hedge the price of their assets by undertaking an exact opposite trade in the derivatives market. Thus, they pass on this risk to those who are willing to bear it. They are so keen to rid themselves of the uncertainty associated with price movements that they may even be ready to do so at a predetermined cost.
For example, let’s say that you possess 200 shares of a company – ABC Ltd., and the price of these shares is hovering at around Rs. 110 at present. Your goal is to sell these shares in six months. However, you worry that the price of these shares could fall considerably by then. At the same time, you do not want to liquidate your investment today, as the stock has a possibility of appreciation in the near-term.
You are very clear about the fact that you would like to receive a minimum of Rs. 100 per share and no less. At the same time, in case the price rises above Rs. 100, you would like to benefit by selling them at the higher price. By paying a small price, you can purchase a derivative contract called an ‘option’ that incorporates all your above requirements. This way, you reduce your losses, and benefit, whether or not the share price falls. You are, thus, hedging your risks, and transferring them to someone who is willing to take these risks.
Speculators: As a hedger, you passed on your risk to someone who will willingly take on risks from you. But why someone do that? There are all kinds of participants in the market.
Some might be averse to risk, while some people embrace them. This is because, the basic market idea is that risk and return always go hand in hand. Higher the risk, greater is the chance of high returns. Then again, while you believe that the market will go up, there will be people who feel that it will fall. These differences in risk profile and market views distinguish hedgers from speculators. Speculators, unlike hedgers, look for opportunities to take on risk in the hope of making returns.
Let’s go back to our example, wherein you were keen to sell the 200 shares of company ABC Ltd. after one month, but feared that the price would fall and eat your profits. In the derivative market, there will be a speculator who expects the market to rise. Accordingly, he will enter into an agreement with you stating that he will buy shares from you at Rs. 100 if the price falls below that amount. In return for giving you relief from this risk, he wants to be paid a small compensation. This way, he earns the compensation even if the price does not fall and you wish to continue holding your stock.
This is only one instance of how a speculator could gain from a derivative product. For every opportunity that the derivative market offers a risk-averse hedger, it offers a counter opportunity to a trader with a healthy appetite for risk.
In the Indian markets, there are two types of speculators – day traders and the position traders.
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A day trader tries to take advantage of intra-day fluctuations in prices. All their trades are settled by by undertaking an opposite trade by the end of the day. They do not have any overnight exposure to the markets.
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On the other hand, position traders greatly rely on news, tips and technical analysis – the science of predicting trends and prices, and take a longer view, say a few weeks or a month in order to realize better profits. They take and carry position for overnight or a long term.
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Margin traders: Many speculators trade using of the payment mechanism unique to the derivative markets. This is called margin trading. When you trade in derivative products, you are not required to pay the total value of your position up front. . Instead, you are only required to deposit only a fraction of the total sum called margin. This is why margin trading results in a high leverage factor in derivative trades. With a small deposit, you are able to maintain a large outstanding position. The leverage factor is fixed; there is a limit to how much you can borrow. The speculator to buy three to five times the quantity that his capital investment would otherwise have allowed him to buy in the cash market. For this reason, the conclusion of a trade is called ‘settlement’ – you either pay this outstanding position or conduct an opposing trade that would nullify this amount.
For example, let’s say a sum of Rs. 1.8 lakh fetches you 180 shares of ABC Ltd. in the cash market at the rate of Rs. 1,000 per share. Suppose margin trading in the derivatives market allows you to purchase shares with a margin amount of 30% of the value of your outstanding position. Then, you will be able to purchase 600 shares of the same company at the same price with your capital of Rs. 1.8 lakh, even though your total position is Rs. 6 lakh.
If the share price rises by Rs. 100, your 180 shares in the cash market will deliver a profit of Rs. 18,000, which would mean a return of 10% on your investment. However, your payoff in the derivatives market would be much higher. The same rise of Rs. 100 in the derivative market would fetch Rs. 60,000, which translates into a whopping return of over 33% on your investment of Rs. 1.8 lakh. This is how a margin trader, who is basically a speculator, benefits from trading in the derivative markets.
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Arbitrageurs: Derivative instruments are valued on the basis of the underlying asset’s value in the spot market. However, there are times when the price of a stock in the cash market is lower or higher than it should be, in comparison to its price in the derivatives market.
Arbitrageurs exploit these imperfections and inefficiencies to their advantage. Arbitrage trade is a low-risk trade, where a simultaneous purchase of securities is done in one market and a corresponding sale is carried out in another market. These are done when the same securities are being quoted at different prices in two markets.
In the earlier example, suppose the cash market price is Rs. 1000 per share, but is quoting at Rs. 1010 in the futures market. An arbitrageur would purchase 100 shares at Rs. 1000 in the cash market and simultaneously, sell 100 shares at Rs. 1010 per share in the futures market, thereby making a profit of Rs. 10 per share.
Speculators, margin traders and arbitrageurs are the lifeline of the capital markets as they provide liquidity to the markets by taking long (purchase) and short (sell) positions. They contribute to the overall efficiency of the markets.
WHAT ARE THE DIFFERENT TYPES OF DERIVATIVE CONTRACTS:
There are four types of derivative contracts – forwards, futures, options and swaps. However, for the time being, let us concentrate on the first three. Swaps are complex instruments that are not available for trade in the stock markets.
·
Futures and forwards: Futures are contracts that represent an agreement to buy or sell a set of assets at a specified time in the future for a specified amount. Forwards are futures, which are not standardized. They are not traded on a stock exchange.
For example, in the derivatives market, you cannot buy a contract for a single share. It is always for a lot of specified shares and expiry date. This does not hold true for forward contracts. They can be tailored to suit your needs.
·
Options: These contracts are quite similar to futures and forwards. However, there is one key difference. Once you buy an options contract, you are not obligated to hold the terms of the agreement.
This means, even if you hold a contract to buy 100 shares by the expiry date, you are not required to. Options contracts are traded on the stock exchange.
HOW ARE DERIVATIVE CONTRACTS LINKED TO STOCK PRICES:
Suppose you buy a Futures contract of Infosys shares at Rs 3,000 – the stock price of the IT company currently in the spot market. A month later, the contract is slated to expire. At this time, the stock is trading at Rs 3,500. This means, you make a profit of Rs. 500 per share, as you are getting the stocks at a cheaper rate.
Had the price remained unchanged, you would have received nothing. Similarly, if the stock price fell by Rs. 800, you would have lost Rs. 800. As we can see, the above contract depends upon the price of the underlying asset – Infosys shares. Similarly, derivatives trading can be conducted on the indices also. Nifty Futures is a very commonly traded derivatives contract in the stock markets. The underlying security in the case of a Nifty Futures contract would be the 50-share Nifty index.
HOW TO TRADE IN DERIVATIVES MARKET:
Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.
·
First do your research. This is more important for the derivatives market. However, remember that the strategies need to differ from that of the stock market. For example, you may wish you buy stocks that are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market, this would need you to enter into a sell transaction. So the strategy would differ.
·
Arrange for the requisite margin amount. Stock market rules require you to constantly maintain your margin amount. This means, you cannot withdraw this amount from your trading account at any point in time until the trade is settled. Also remember that the margin amount changes as the price of the underlying stock rises or falls. So, always keep extra money in your account.
·
Conduct the transaction through your trading account. You will have to first make sure that your account allows you to trade in derivatives. If not, consult your brokerage or stock broker and get the required services activated. Once you do this, you can place an order online or on phone with your broker.
·
Select your stocks and their contracts on the basis of the amount you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have to pay a small amount to buy the contract. Ensure all this fits your budget.
·
You can wait until the contract is scheduled to expiry to settle the trade. In such a case, you can pay the whole amount outstanding, or you can enter into an opposing trade. For example, you placed a ‘buy trade’ for Infosys futures at Rs 3,000 a week before expiry. To exit the trade before, you can place a ‘sell trade’ future contract. If this amount is higher than Rs 3,000, you book profits. If not, you will make losses.
Thus, buying stock futures and options contracts is similar to buying shares of the same underlying stock, but without taking delivery of the same. In the case of index futures, the change in the number of index points affects your contract, thus replicating the movement of a stock price. So, you can actually trade in index and stock contracts in just the same way as you would trade in shares.
WHAT ARE THE PRE-REQUISITES TO INVEST
As said earlier, trading in the derivatives market is very similar to trading in the cash segment of the stock markets.
This has three key requisites:
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Demat account: This is the account which stores your securities in electronic format. It is unique to every investor and trader.
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Trading account: This is the account through which you conduct trades. The account number can be considered your identity in the markets. This makes the trade unique to you. It is linked to the demat account, and thus ensures that YOUR shares go to your demat account.
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Margin maintenance: This pre-requisite is unique to derivatives trading. While many in the cash segment too use margins to conduct trades, this is predominantly used in the derivatives segment.
Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required to deposit only a percentage of the value of your outstanding position with the stock exchange, irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money, covers an initial margin and an exposure margin. These margins act as a risk containment measure for the exchanges and serve to preserve the integrity of the market.
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You are expected to deposit the initial margin upfront. How much you have to deposit is decided by the stock exchange.
It is prescribed as a percentage of the total value of your outstanding position. It varies for different positions as it takes into account the average volatility of a stock over a specified time period and the interest cost. This initial margin is adjusted daily depending upon the market value of your open positions.
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The exposure margin is used to control volatility and excessive speculation in the derivatives markets. This margin is also stipulated by the exchanged and levied on the value of the contract that you buy or sell.
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Besides the initial and exposure margins, you also have to maintain Mark-to-Market (MTM) margins. This covers the daily difference between the cost of the contract and its closing price on the day of purchase. Thereafter, the MTM margin covers the differences in closing price from day to day.
155 Views · 3 Upvotes
Steve Traugott, Former derivatives trading systems engineer
Updated Apr 30
Short answer:
A derivative is a financial instrument whose value is derived from the value of one or more other financial instruments. Stock options are simple derivatives, and individuals can trade options via retail brokers. Though simple, even options have a steep learning curve, and most retail options traders operate at a loss.
Longer answer, more theoretical, but if you ignore derivatives pricing theory you will quite literally not know what you are trading:
A derivative instrument is one whose value is typically assumed to be equal to f(x), where x is the value of another financial instrument, and f() is some function or algorithm that is implied by the derivative instrument’s contract or prospectus.
If your eyes are glazing over right about now and you skimmed through the previous paragraph without really reading it, then don’t trade derivatives. Your account balance will thank you.
An example of a simple derivative is a call option on IBM stock, where x is the stock price, and f(x) = the option price. In this case, f() is often assumed to be an equation such as Black-Scholes-Merton, or some more complex model, depending on who you ask and why they are trading the option. All of these versions of f() are also assumed to be slightly wrong, which brings us to the need for an equity options market to discover what f(x) actually is at any given moment.
An example of a more complex derivative is a mortgage-backed security, which might be constructed by piling a few thousand mortgages into one big fund, and then selling bonds against the whole thing as if the fund were a mortgage lender and the bonds were loans to the lender in return for a share of the mortgage interest income. In this case, those bonds are derivatives, x is the value of those mortgages, and f(x) is the bond value. In order to come up with f(), you have to make assumptions about how many of those mortgages will default. What happened to the global economy in 2008 was in part due to a realization that many assumptions about mortgage f() were more than “slightly” wrong, followed by a complete lock-up of the market, because if you can’t trust whatever you’re using for f(), you’d be crazy to trade f(x). This rippled throughout the economy, because mortgages, equities, currencies, and commodities are all interdependent via their own derivative functions. It took months for researchers to come up with new versions of f(), and it’s taking years for the world to form trust in those new versions.
How do you invest in them? First, you take an amount of money that you intend to lose (because you will), then you try to come up with a better f() for some instrument, like call options on IBM, then write a model for f() in C, Python, Matlab, R, or your language of choice. Then you give all that money to a broker that supports trading in that instrument (one that supports equity options trading, in this case), and then you trade according to your model. You will quickly learn that the market itself is the only true f(), and that your own model is a deranged, maliciously dangerous toy at best. You then decide you should have paper-traded instead of using real money, so you try that for a while, refining f() until you think it really works. Then you go back to real money again, and discover that fills, commissions, and execution risk are a large part of f(), and your model is still deranged, but in entirely new ways. Wash, rinse, repeat. How successful you are at this depends in large part on how much time and money you can afford to spend on learning, combined with pure luck in discovering a usable f() early enough that you can profit from it before others discover it and arbitrage it away.
Which brings us to the last point: f() itself is not a fixed formula. A complete model of f() would look like a genetic algorithm, with many models competing and the most accurate bubbling to the top and then down again as news events alter f() in a continuous process of financial darwinism. Which is, after all, what a market is.
792 Views · 9 Upvotes
Nisha Sharma, studied at MBA in Finance
Answered Oct 16
Derivatives, As the name suggests, derivatives are the financial instrument whose value is derived from an underlying asset. It can be anything from stock, commodity, Forex and bonds. Derivatives were invented as a hedging tool, however over the period of time these has been used as trading tools.
A derivative is a contract between two parties which derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps.
Derivatives further classified into two
1. Over the Counter ( OTC)
The derivatives traded between two parties buyer and seller directly without the involvement of exchange or any other financial intermediary. These contract are not traded through any central exchange. The OTC derivative encounters default risk .As if one party disagree to abide by the terms of the contact.
2. Exchange traded
Derivatives traded over exchange falls under this category. The contacts are traded over the exchange which act as intermediary between the buyer & seller thus eliminates the counter party risk.
TYPE OF DERIVATIVES
· Forward Market: Simplest and oldest form of derivative prevailing in the market is forward contract. It’s an agreement to sell or buy something at future date at pre decided price. No exchange is involved as an intermediary, thus increasing the chances of counter party credit risk. This is traded over the counter (OTC)
· Future Market: This is very similar to forward contract. Similarity between forward and future contract is the basic condition, i.e, to sell or buy something at future date at pre decided price. Future contracts are registered over the exchange, acting as an intermediary, which makes the contract standardized and an agreement which can’t be modified. Exchange contracts come with pre defined size, format, price and expiration. As this contracts are traded over exchange, so they also have to follow the settlement procedure, i.e to settle gain and losses on daily basis, thus negating the chances of counter party credit risk.
Below are some of the future market segment:
Interest rate derivatives: The underlying asset is a standard interest rate. Examples of interest rate OTC derivatives include LIBOR, Swaps, US Treasury bills, Swaptions and FRAs.
Commodity derivatives: The underlying are physical commodities like wheat or gold. E.g. forwards.
Forex derivatives: The underlying is foreign exchange fluctuations.
Equity derivatives: The underlying are equity securities. E.g. Options and Futures
Fixed Income: The underlying are fixed income securities.
Option: Option contract, is different from forward and future contracts, as in these two types of contracts, both the parties are bound to perform their duties as mandated by the contracts. However an options contract, binds one party whereas it lets the other party decide at a later date. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price.
SWAPS: One of the most complicated derivative contract is the SWAPS; it enables the participants to exchange the stream of cash flow. Most traded SWAPs are the interest SWAP, the second most used SWAPs in the market is the Currency SWAPS, used by MNC’s to hedge their currency risk. Swap contracts are usually not traded on the exchange. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts, so counter party risk does exist in SWAP contracts.