What are Derivatives? Meaning & Derivatives Types

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Suppose you are at a jewellery store with many beautiful ornaments around you. You notice that the price of gold has fluctuated in the last few days, sometimes rising and sometimes falling. To deal with this uncertainty, you decide to secure a deal with a jeweller to buy gold at a fixed price next month. This agreement protects you from future price hikes. In the world of finance, this is similar to what derivatives do. They are financial contracts whose value is derived from the performance of an underlying asset. This article will help you understand derivative’s meaning and explore their different types.

What are Derivatives?

A derivative is a financial instrument that gains value from its underlying benchmark, asset, or group of assets. Such contracts represent agreements between multiple parties and can be traded either on exchanges or at OTC (over the counter). Traders use derivatives to hedge risks or speculate on the price action of the underlying assets.

Components of a Derivative Contract

A derivative contract typically includes several key components that define its structure and function:

• Underlying Asset: This asset is what determines the value of the derivative on a derivative app. It can be stocks, bonds, commodities, currencies, interest rates, or other derivatives.
• Contract Size: It refers to the quantity of the underlying asset the contract covers. For instance, a futures contract may represent 100 barrels of oil.
• Expiration Date: The contract must be settled by this specific date. For futures and options, it is the time limit the holder must act—either by exercising their right or fulfilling the contract.
• Strike Price: The pre-decided price at which you can purchase or sell assets. The strike price decides whether the option will be profitable.
• Premium: In options, this is the amount the buyer pays the seller for the rights granted by the option.
• Settlement Terms: They outline how the contract will be settled, whether through the physical transfer of the asset or via cash settlement.
• Counterparty Risk: This is the potential risk that one of the contract’s participants may not meet their obligations. Over-the-counter (OTC) derivatives generally carry higher counterparty risk than exchange-traded derivatives.

Types of Derivatives

Derivative contracts are classified into the following four types:

1. Futures

Futures are agreements in which the buyer commits to buying or the seller agrees to sell an asset at a set price on a specified future date. These standardised contracts are traded on a futures exchange, providing liquidity and high transparency.

Suppose you expect crude oil prices to surge in the next six months. You choose to purchase a futures contract for 1,000 barrels of oil at ₹5,000 per barrel, with the contract set to expire in six months. 

If, by the expiration date, the price of oil increases to ₹6,000 per barrel, you sell the contract at the new market price, earning a profit of ₹1,000 per barrel. On the other hand, if the price drops to ₹4,000 per barrel, you are compelled to execute the trade and face a loss of ₹1,000. 

2. Swaps

Swap derivatives are agreements in which two parties exchange cash flows or financial assets over a predetermined timeframe. These deals help mitigate risks related to interest rates, currency changes, or other financial uncertainties. Unlike standard instruments traded on derivatives market exchanges, swaps are mainly OTC agreements, allowing for customisation to suit the parties’ needs. This flexibility makes swaps a valuable tool for managing financial risk.

Consider a U.S. business requiring euros and a European company needing dollars. They agree on currency derivatives in which the U.S. firm borrows euros from the European company and lends an equivalent dollar amount. They swap $10 million for €8 million at a 1.25 exchange rate. Throughout the swap, the U.S. company pays interest in euros, while the European firm pays in dollars. Upon maturity, they return the principal amounts, protecting both from currency risk.

3. Forwards

In forward derivative trading, two parties enter into a tailored agreement to exchange an asset at a prearranged price on a stated date in the future. This differs from standardised futures contracts on exchanges that lack customisation flexibility.

For example, assume yourself a farmer who expects to harvest 1,000 kilograms of wheat in six months. You are concerned that the price of wheat might drop by the time of harvest. You enter into a forward contract with a local miller to mitigate this risk. You agree to sell your wheat at ₹20 per kilogram in six months. Regardless of the market price at that future date, the miller will buy your wheat at the agreed price of ₹20 per kilogram.

This agreement benefits both parties: you, as the farmer, get a set price for your wheat, protecting yourself from possible price decreases. Meanwhile, the miller secures a fixed price, guaranteeing a consistent cost for their raw materials. However, it is crucial to understand that forward contracts involve counterparty risk. If one party defaults, the other may suffer financial losses.

4. Options

An options contract provides you the choice, without obligation, to either acquire or sell an underlying asset at a defined price before a certain deadline. There are two types of options: call options, which offer the right to buy, and put options, which grant the right to sell.

Let’s consider an example involving a call option on HDFC Bank Ltd. 

Let’s say you are optimistic about the HDFC Bank stocks, currently valued at ₹1,600, and expect it to increase. Through a stock app, you invest in a call option with a strike price of ₹1,700, which expires in one month, for a premium of ₹50 for every share. This option grants you the right to acquire 100 shares of HDFC Bank at ₹1,700 per share.

If HDFC Bank stock price rises to ₹1,800 before the option expires, you can exercise your option to buy at ₹1,700, making a profit of ₹100 per share (₹1,800 – ₹1,700), minus the premium paid (₹50), resulting in a net profit of ₹50 per share. Conversely, if the stock price stays below ₹1,700, you allow the option to expire, limiting your equity derivative loss to the premium paid.

Differences Between Derivatives

While derivatives serve similar functions, they have distinct characteristics that affect their use and risk profiles. Here’s a comparison of the main types:

Importance of Derivatives

• Price Discovery: The trading of derivatives in the stock exchange reflects market participants’ expectations about future price movements. It provides insights into the future pricing of underlying assets.
• Leverage: Derivatives enable investors to gain exposure to larger positions in the market without requiring a substantial initial capital outlay. This leverage can amplify potential returns but also increase risk.
• Speculation: Traders use stock market derivatives to speculate on future price movements. By betting on price changes, traders can profit from market fluctuations, even in declining markets.
• Diversification: Derivatives can expose investors to a range of assets and markets, allowing for greater diversification of investment portfolios.

Conclusion

Derivatives are monetary contracts whose worth is linked to an underlying asset, like stocks or commodities. They come in various forms, including futures, swaps, forwards, and options, each serving different purposes and risks. As a trader, derivatives allow you to hedge against price fluctuations, speculate on future prices, and discover market trends. Understanding the types and functions of derivatives can help you profit from the financial markets while allowing you to make informed investment and risk management decisions.

If you want to start your derivative trading journey today but are unsure where to get started, turn to the HDFC SKY Derivatives app. All you need to do is open Demat account and explore the various opportunities available.