Types of Derivatives in Financial Markets

• The term ‘derivative’ refers to a financial contract that derives its value from an underlying asset.
• The different types of derivatives in finance include options, futures, forwards and swaps.
• It is essential to understand the ongoing market conditions before you start investing in different types of derivatives.

Let us first understand what are derivatives. The term derivative refers to a financial contract that derives its value from an underlying asset, such as stocks , commodities, currencies or bonds . It is set between two or more parties, a buyer and a seller, who can trade securities over an exchange or over the counter.The price of the derivative is primarily dependent on fluctuations in the value of the underlying asset. Derivatives are mainly traded to hedge against risks and can be used to either mitigate risk or assume risk with the expectation of reaping gains.

Now, let's discuss the different types of derivatives in finance:

Options

An options contract is one of the types of derivative finance wherein the buyer has the right to trade the underlying asset over a predetermined time. The price determined by the buyer and the seller is called a strike price and the seller of the option is called the option writer.In an options contract, the buyer is not obligated to exercise the option to trade the underlying asset. If he or she does not want to exercise the options contract, they can pass on the right after paying a premium to the option’s writer.

Futures

A futures contract is a legal agreement between a buyer and a seller of an underlying asset, such as a stock, bond, or commodity. A predetermined quantity and price are agreed upon in a futures contract that is payable at a specific future date.Unlike in an options contract, the parties involved in a futures contract are legally bound to exercise the contract, which remains valid until the time of expiry.Futures are always traded via an exchange. Traders use a futures contract to hedge their risk or speculate on the price of an underlying asset to reap additional profits.

Forwards

The buyer and seller of a forward contract are also obligated to execute the contract just like in a futures contract. However, forwards are traded over the counter instead of an exchange.Forwards also offer the buyer and the seller the option to customise the contract as per their requirements, related to the terms, size,and settlement process.Forward contracts carry a higher degree of counterparty risk, which is a credit risk when the involved parties may not be able to live up to the obligations of the contract.

Swaps

Swaps are another type of derivatives that are traded over-the-counter and enable the buyer and seller to swap their financial obligations. They are used to exchange one type of cash flow with another.The cash flows in swap derivatives are based on a rate of interest; while one cash flow is generally fixed, the other can be changed. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan and vice versa. Also Read: What are Financial Derivatives ?

It is essential to understand the market before you start investing in different types of derivatives in finance. Investors should educate themselves about the ongoing market conditions along with the economic, political and social factors that could affect trade. Furthermore, trading in different types of derivatives comes with its own advantages and risks.Hence, investors should be aware of the potential losses before they start trading in financial derivatives types.