What are derivatives in Finance? Comprehensive explanation with examples

 

If you are new to the stock market or a management student or curious to learn components of the financial market, you might have heard the term derivatives. In this article, I will explain to you about derivatives in simple words with examples. You would be able to learn the following terms by the end of this article.

What are derivatives? (Meaning and definition)Functions of derivatives 

  • Characteristics of derivatives 
  • Types of derivatives 
  • Difference between Future and forward contracts
  • Difference between Future and Option contracts
Before we begin, first let me explain the hierarchy of the financial market. Financial markets are broadly classified into 3 categories; Money Market, Capital Market and Forex Market.
 
Let us explore the capital market which further classified in the debt market (bond market) and equity market (share market or stock market).  The equity market is further classified into the spot market and derivative market (see the following hierarchy).

what is derivative market

The term “Derivatives” is related to the derivative market only.

What are derivatives?

“A derivative is a contract of selling or buying of financial securities between to parties expected to settle on a future specific date and its value is derived from the value of underlying assets ”

The underlying assets could be anything such as shares, bonds, commodities, precious metals, currency or interest rates.
 
In other words, the derivative is an agreement between to traders for selling or buying of shares, commodities, currency in future at a price agreed today only. No investment or very few investments required to enter such a contract.

It gives the right to buy or sell the securities such as shares, commodities, bonds or currency on previously agreed price irrespective of the price of the same in the spot market.

Now the question arises, what is the worth of this type of contract? The value of this contractual agreement changes with the price movement of the mentioned security in the spot market.

Let us understand it with an example.

Consider A and B are the traders in the stock market. B has 100 shares of XYZ ltd which price quoted in the cash market is Rs. 500.

A comes to B and offers a proposal to purchase 100 shares of XYZ ltd at the rate of Rs. 500 at some specific date in future. B agreed and both sign a contract together for the same.

However the price of shares of XYZ Ltd is not going to be stagnant, it will definitely fluctuate with respect to time.

Let us assume that the price of that share becomes Rs. 550 per share after a few days in the cash market. Now this contractual agreement will show its importance, A is still eligible to buy the same share at the rate of Rs. 500 only. 

Hence A will make a profit of  Rs.50 per share by this contract and the total profit made by A will be Rs. 5000 without any substantial investment.

Here the underlying asset is the equity share in XYZ Ltd.Characteristics of Derivatives. 

  1. Transactions in derivative are settled by squaring off such transactions in the same underlying and the difference of the value of the derivative is settled in cash.
  2. There is no physical asset transacted in the derivative market that’s why there is the unlimited unit of transactions.
  3. The financial derivatives are the components of the secondary market, therefore business entities can not raise funds by derivative instruments.
 
 

 Functions of Derivatives:

The functions of derivative instruments are described below.
  1. The derivatives assist to encounter the financial risks associated due to fluctuation of price, interest rate and currency exchange rate.
  2. The financial derivatives protect sellers from loss due to price fluctuation ( price downfall) because it ensures the commitment of the price of financial securities in future.
  3. It also provides a platform to speculate and make a profit for those who are ready to take risks.
  4. The financial derivatives transfer the risks from those who want to avoid it to those are ready to accept it.

Types of Derivatives:

There are four types of financial derivative in the derivative market.

types of derivatives  

Future contract:

A future contract is an agreement between two parties in which one party commits to buying and other party commits to sell specified units of specified assets on a specific date in future at a price agreed by both. 
Some features of the futures contract are:

  • The futures contracts are a standardised contractual agreement in terms of quality, date of settlement and price (margin money).
  • It is regulated by the derivative market (stock exchange) and performs as clearinghouses agency, hence eliminating the risk of defaults. Thus stock exchange encourages the trading of futures contracts as it guarantees the performance.
  • The derivative market requires to maintain a deposit (margin money) from parties and the margin changes with respect to daily prices. The profits and losses are settled on a day-to-day basis.

Forward contract:

 
A forward contract is OTC (over the counter) type contract which is not regulated under the stock exchange or derivative market. It is not marketable derivative instruments and therefore, performed and settled by both the parties directly.
 
Now let us understand a few differences between future and forward contracts.

Difference between Future and Forward contracts:

There are some major differences between future and forward contract which are:
  1. Future contracts are exchange regulated whereas forwarding contracts OTC types.
  2. Future contracts are marketable but forward contracts are not.
  3. Future contracts are a standardised form of derivative whereas forward contracts can be customised by both the parties as per their mutual understandings.
  4. Forward contracts are unique and have to be settled by both original parties because it is non-tradable instruments but on the other hand in case of futures contracts, investors can sell and exit from contract any time during the contract.
  5. Forward contracts are risky and there is a chance of default whereas future contracts are safe as the stock exchange itself regulates it.
  6. There may or may not be the initial margin money or token money but in case of future contracts, initial margin deposit is compulsory.
  7. Forward contracts may be done for actual trading (buying and selling) on the other hand in future contracts price differences are settled in cash into the beneficiary accounts.

Option Contracts:

An option contract is a contract between two parties to buy or sell shares, commodities or currency in future date at a price agreed today but option holder is not bound to exercise this contract at the date of maturity. It is up to the option holder whether he wants to exercise it or not.

In other words, In an option contract, one party gives the right to buy or sell securities to another party in the future date at a specific price.

Two parties are involved in an option contract, one who gives the right to purchase or sell it is called as ‘Option writer’ and the second party who holds the right is called as ‘Option holder’.

The option contracts are of two types.

classification of option
Classification of Options

 

Call Option:

Call options are those options contracts in which option writers give and option holder hold the right to buy securities.

Put Option:

Put options are those in which option writers give and option holder posses the right to sell the shares, commodities, currency etc.

The option contracts can also be categorised on the basis of date or period of maturity.

American Option:

The European option is those options contract which is exercisable on or before the maturity date. That means option holder can exercise the option contract on or before (at any point) the expiry date.

European option:

These options are exercisable on maturity date only. It means the option holder can exercise the option contract only on the maturity date or expiry date not before the expiry date.

Option premium (price) and strike price:

The option premium is an upfront price payable by the option holder to the option writer at the time of signing the contract.
The option premium is mandatory to pay whether the option is exercised or not.

The price offered by the option writer to sell or buy the securities to the option holder at the time of the contract is called strike price or exercise price.

Difference between Future and option:

Future contracts and options contracts both are the financial instruments of the derivative market generally used by investors to speculate for making a profit and hedging the current investment (portfolio). Although the functions of both the derivatives are same yet there is a major difference between both the contracts. The future and option contracts both provide the right to buy or sell the securities.

  • The option holder is under no obligation to settle the option contract whereas in case of future contracts the future holder is under obligation to settle (buy or sell) the contract on the date of maturity.
  • In future contracts, whether it is seller or buyer both the parties are under obligation to exercise the contract; this means neither seller nor buyer can refuse to settle the contract on the other hand in option contracts, the option writer would be under obligation to settle  the contract only  when the option holder exercises the contract.
  • There may or may not be initial deposit (margin money) in future contracts and margin money might vary with size (quantity) of shares whereas in option contracts option premium are fixed and mandatory at the time of contract.

Swap Contract:

The swap derivatives are a type of contract that facilitates to interchange the financial obligation between two parties. It is the OTC (over the counter) type contract and doesn’t trade in the stock exchange.

Swap contracts are generally used to interchange interest rates between two borrowers with the help of swap banks.

There are two types of interest rate, fixed rate of interest and floating rate of interest.

The fixed interest rate is fixed throughout the loan period irrespective of current interest rates whereas the floating interest rates are flexible and vary with the MIBOR in India.

MIBOR (Mumbai Interbank Offer Rates): MIBOR is the rate of interest on which banks take the loan.

Let us understand the swap contract with an example. Suppose A and B are two parties who borrowed Rs.10 lacs from different banks. However, A has borrowed at a fixed rate of interest (for example 7%) and B has borrowed at a floating rate of interest (MIBOR+1.4%).

Now A wants to change the interest rate to floating interest rates as he predicts the interest rates are going to down. Similarly, B predicts interest rate is going to increase, hence he wanted to go for a fixed interest rate.

Thus both A and B want to change their interest rates and they approach an intermediary called swap banks to interchange their interest rates.

Thus A and B interchanged their financial obligation and this is called as swap contracts.

Hope you would have enjoyed this lesson about derivatives. You may also interested in the following terminology of finance.

Indian financial system | Components | Definition and function

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