There are four different types of derivatives that can easily be traded in the Indian Stock Market. Each derivative is different from the other and consist of varying contract conditions, risk factor and more.
Let us have a look and study in-depth detail about these derivatives.
Forward contracts mean two parties come together and enter into an agreement to buy and sell an underlying asset set at a fixed date and agreed on a price in the future.
In simpler words, it is an agreement formed between both parties to sell their asset on an agreed future date.
The forward contracts are customized and have a high tendency of counterparty risk. Since it is a customized contract, the size of the agreement entirely depends on the term of the contract.
Forward contracts do not require any collateral as they are self-regulated. The settlement of the forward contract gets done on the maturity date, and hence they are reserved by the expiry period.
Future contracts are similar to forward contracts. Future contracts mean an agreement made by the two parties to buy or sell an underlying instrument at a fixed price on a future date.
Future contracts do not allow the buyer and seller to meet and enter into an agreement. In fact, the deal gets fixed through exchange mode.
In futures contracts, the counterparty risk is low because it is a standardized contract. In addition, the clearinghouse plays the role of a counterparty to the parties of the contract, which reduces the credit risk in the future.
The size of future contracts is fixed, and it is regulated by the stock exchange just because it is known as a standardized contract.
Since these contracts are standard, the futures contracts listed on the stock exchange cannot be changed or modified in any possible way.
In simpler words, future contracts have pre-decided size, pre-decided expiry period, pre-decided size. In futures contracts, an initial margin is required because settlement and collateral are done daily.
Options contracts are the third type of derivative contracts in India. Options contracts are way different than future and format contracts because these contracts do not require any compulsion to discharge the contract on a specific date.
Options contracts provide the right but not the commitment to buy or sell an underlying instrument.
Option contracts consist of two options:
- Call Option
- Put Option
Incall option, the buyer has all the right to purchase an underlying asset at a fixed price while entering the contracts. While input option, the buyer has all the right but not obligation to sell an underlying asset at a fixed price while entering the contract.
However, in both call and put option contracts, the buyer chooses to settle all the contracts on or before the expiry period.
Thus, anyone who regularly trades in the option contract can take any of the four different positions, i.e., short or long, either in the call or the put option. These options are traded at the stock exchange and over the counter market.
Out of all three derivatives contracts, swap contracts are one of the most complex contracts.
Swap contracts mean the agreement is done privately between both parties. The parties who enter into swap contracts agree to exchange their cash flow in the future as per the pre-determined formula.
Under swap contracts, the underlying security is the interest rate or currency, as these contracts protect both parties from several major risks.
These contracts are not traded to the Stock Exchange as investment banker plays the role of a middleman between these contracts.
