Derivatives generally derive their value from underlying assets like Stocks, Currencies, Indices, Commodities, and Exchange-Traded Funds. Investors trade in Financial Derivatives to earn profits by speculating on the underlying asset’s value.
There are four types of contracts under the Derivatives Market:
Futures are standardised contracts that allow the holder to buy or sell an asset at a pre-agreed price and date. The parties involved in the contract must honour the contract. Such contracts are traded on the stock exchanges, like Nifty Derivatives. The value of the Futuresgets adjusted according to the market movements until the expiry date. This phenomenon is also calledMark to Market margin.
Unlike Futures, Options give the traders the right and not the obligation to honour the contract. They can decide whether they want to buy or sell the security at an agreed price and date. This helps investors cap their losses. The seller of Options is calledan Options writer. The specified price is called the Strike Price. You can exercise Options any time before the expiry date, which is the last Thursday of the month.
Currency Derivatives get their value from an underlying asset: Currencies. Such Derivatives are standardised and usually traded on a foreign regulatory exchange. So, there are zero to minimal counterparty risks involved. Besides, traders must honour the rules and regulations of the exchange. Like Derivatives, Currency Derivatives are of two types: Futures and Options.
The only difference here is that the underlying asset is a currency. Traders combine the two types to manage their risk.
Forwards are like Futures contracts butare customised according to the underlying asset: amount and price. While the holders heremust honour the contract, they can be customised according to the parties’ wishes. This is massive because these Derivatives are not unstandardised and not traded on exchanges. Such Derivatives are also called Over the CounterDerivatives.
Swaps are the fourth type in which two parties exchange their financial obligations or cash flows without involving exchanges. Both parties agree on a notional principal rate without exchanging principal as part of the agreement. The cash flows depend on the interest rates, index price, or currency exchange rates. Institutions rather than retail investors dominate the Swaps Marketowing to the risk involved in the OTC market.
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