Introduction of Future Market : Types of Derivatives : AS Chakravarthy

Introduction of Future Market : Types of Derivatives : AS Chakravarthy

Stock Market : Technical Analysis Training Hyderabad: AS Chakravarthy

A future Market contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction.

The standardized items in a futures contract are:

  • Quantity of the underlying
  • Quality of the underlying
  • The date and the month of delivery
  • The units of price quotation and minimum price change
  • Location of settlement

Types of Derivatives

Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage.

Forwards: A forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today’s future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded.

Options: There are two types of options – call and put. A Call option gives 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. A Put option gives the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.

The two commonly used swaps are:

  • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
  • Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

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