Derivatives are financial contracts whose value is determined by the underlying asset or group of assets. Stocks, bonds, currencies, commodities, and market indices are the most commonly used assets. As market conditions change, so do the values of underlying assets. Through derivative contracts, profits are earned by speculating on what the underlying asset will be worth in the future.
Consider the possibility that the market price of an equity share could rise or fall. If the stock value falls, you may suffer a loss. By making an accurate trade, you might be able to earn gains through a derivative contract in this situation. After understanding derivatives definition in the share market, let’s learn the types of derivatives and their benefits in this article.
Types of Derivative Contracts
In the share market, options, forwards, futures, and swaps are major types of derivatives contracts.
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Forward Contracts
In a forward contract, two parties agree to buy and sell an underlying asset in the future at a fixed price and a fixed date. Simply put, it is an agreement between the two parties to sell their assets at an agreed time in the future.
It is a customised contract and there is a high tendency for counterparty risk. The size of the agreement will depend entirely on its terms. Since forward contracts are self-regulated, collateral is not required. In forward contracts, settlement occurs on the maturity date, so they are reserved until the expiration date.
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Future Contracts
A futures contract involves two parties agreeing to purchase or sell an underlying instrument at a future date at a fixed price. However, the deal is fixed through exchange mode. Since futures contracts are standardised, counterparty risk is low. Additionally, the clearinghouse serves as a counterparty to the contract parties, thereby reducing future credit risk.
As standardised contracts, future contracts have a fixed size, which is regulated by the stock exchange. Also, being standard contracts, they cannot be modified or changed in any way. Future contracts have predetermined sizes, predetermined expiration periods, and predetermined sizes. Due to the fact that futures contracts are settled and collateralised on a daily basis, an initial margin is required.
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Options Contracts
The third type of derivative contract in India is the option contract. As opposed to futures and forward contracts, options contracts are not obligated to end on a specific date. Options contracts grant the right to buy or sell an underlying instrument but not the commitment to do so.
There are two types of option contracts:
- Call Option
- Put Option
A call option gives the buyer the right to buy the underlying asset at a specific date in the future but not the obligation to do so. A put option gives the buyer the right to sell the underlying asset at a future date but not the obligation.
To acquire the right to buy or sell an option, the holder must pay a deposit called a ‘Premium’. As part of a contract, a predetermined price is agreed upon, known as the Strike Price. It is at this price that the option may be exercised.
Anyone who regularly trades in the options contract can take four different positions, i.e. short or long, either in the call or put options. Also, these options contracts are traded at the stock exchange and over the counter market.
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Swap Contracts
The swap contract is one of the most complex derivatives contracts among the three. A swap contract is a private agreement between two parties. In swap contracts, the parties agree to exchange their cash flow in the future based on a predetermined formula.
In swap contracts, the underlying security is the interest rate or currency because these contracts protect both parties from several major risks. As investment bankers act as middlemen between these contracts, they are not traded on the stock exchange.
Benefits of Derivatives
Listed below are a few crucial benefits associated with derivatives.
1. Risk Management
A derivative is one of the best tools for risk hedging, or reducing risk in one investment by making another. The use of derivatives is commonly seen as a risk management tool and as a way to mitigate market risks.
2. Liquidity
It is easy to buy and sell derivatives on the open market because of their high liquidity. It allows investors to profit quickly from price fluctuations without spending a lot of money.
3. Leverage
A derivative can be used to increase leverage and amplify returns. Investors can borrow money with derivatives, allowing them to place larger trades than they could without them.
4. Access
The use of derivatives allows investors to trade in a variety of asset classes across a variety of markets. The strategy may be beneficial to investors who wish to diversify their portfolios.
Conclusion
The purpose of derivatives is to hedge risks, manage exposure, and speculate on the movements of underlying assets. Through derivatives, investors can participate in the financial markets without owning the underlying assets. Investors can use the best stock trading app to trade derivatives. Understanding and using derivatives requires a great deal of knowledge and research. Before trading in derivatives, investors should read and understand the terms and conditions.