Derivatives is a contract between two or more parties that derives its value from underlying assets such as securities. These underlying assets include bonds, currencies, future and forward contracts, market indexes, stocks and commodities. The buyer agrees to purchase the underlying assets at specific cost and specific time. The value of these assets are affected by the performance of underlying contract. Generally the derivatives are used for speculating and hedging purpose and the speculators intend to generate profit out of change in value of underlying assets.
Types of Financial Derivatives
- Forward Contract
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Forward contract are simplest and oldest forms of derivatives available today. It is nothing bust an agreement to sell something in future date the price for which is decided at present date. These types of contracts takes place between two counterparties. Thus it carries risk of credit and also trusting a counterparty is a risky task for the investor in forward contract.
Also Read : Derivatives: A Risky Or Beneficial Affair?
- Future Contracts
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A future contract is similar to forward contract as in both the contracts the sale is done on future date at a predefined price but the only difference here is that the future contracts are listed on an exchange. In such contracts the exchange plays the role of intermediary hence the contracts are more standardised and cannot be modified. These contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. An important point here is that the buyer and the seller do not enter into contract directly rather they transact through exchange.
- Option Contract
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The option contract are different from other two types stated above as in contracts stated above both the parties are bound by the contract for selling or buying at the predetermined value and time. In options contract one party has the obligation to buy or sell at a predetermined price whereas the other party has the liberty to contract. There are mainly two types of options – Call option and Put option. Call option gives you the right to buy something at a later date at a given price whereas put option gives you the right to sell something at a later date at a given pre decided price but not the obligation to do the same.
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Swaps are one of the most complicated derivative options as it gives liberty to change the stream of their cash at an uncertain time. The most common example for this is changing from fixed interest rates to floating one. Swap helps companies to avoid foreign exchange risk. These are private contracts and are not used in any kind of exchanges. Usually the investment banker plays the role of intermediaries and thus it carries risk factor as well.
Thus there are basically these four types of financial derivatives which are most commonly used by the investors. These also carries risk such as it is mostly impossible to know the real value of derivatives. Also it carries time restriction so there are chances of losing good deal of funds if you have not done proper data analysis. Hence it is better to go for derivative investment after doing proper “Homewor”.