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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