Derivatives: Meaning, Types and Features
Derivatives are products whose value is derived from the value of one or more basic variables, which are called Underlying Assets. The underlying asset can be equity, index, foreign exchange (Forex), commodity or any other asset. This means that any instrument that derives its value on its underlying equity, index, foreign exchange (Forex), commodity or any other asset, is a Derivative Instrument.
Please note that derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. But after 1970s, the financial derivatives came into spotlight thanks to the growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products.
Types of Derivatives
The derivatives can be Forwards or Futures or Options or Warrants.
Forward & Future Contract: A forward contract is a customized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. Futures contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts, such as futures of the Nifty index.
Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types – Calls and Puts options.
- ‘Calls’ give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
- ‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. Please note that options generally have lives of up to one year. The majority of options traded on exchanges have maximum maturity of nine months. Longer dated options are called Warrants and are generally traded over-the counter.
Basic Terms about Derivatives
We suppose that Suresh wants to buy a house in next year October. At the same time, Ramesh has a house worth Rs. 15 Lakh and he plans to sell it in October next year. Since the current price is Rs. 15 Lakh, Ramesh and Suresh enter into an agreement via which Suresh will buy that house in October 2013 in Rs. 17 Lakh. This would be called a Forward Contract. The price agreed upon would be called Delivery price. Since Suresh is buying it, for him, it would be called Long Forward Contract. On the other side, Ramesh is selling it; it would be called Short Forward Contract.
Now, we suppose that in next year October, instead of Rs. 17 Lakh, the market price of that house becomes Rs. 20 Lakh. Since Ramesh is already in contract with Suresh to sell him the house in Rs. 17 Lakh, Suresh would earn a profit of Rs. 3 lakh. Ramesh would lose Rs. 3 Lakh. Here we note that forward contract is in contrast with the Spot contract. Spot contract is an agreement to buy or sell an asset today.
There is one more term related to Forward Contracts called NDF or Non-Deliverable Forward. Non-deliverable forwards are over-the-counter transactions settled not by delivery but by exchange of the difference between the contracted rate and some reference rate such as the one fixed by the Reserve Bank of India. For example, if Ramesh pays Suresh Rs. 3 Lakh without delivering the actual house, it would be called NDF. The same is basic funda for commodity forward contracts and currency forward contracts.