Financial Derivatives

1. Introduction

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 1.5 Types of Derivatives

TYPES OF DERIVATIVE CONTRACTS

1. Derivatives can be classified in 3 ways: On the basis of the nature of the derivative contract
2. On the basis of the Underlying asset
3. `On the basis of the place of trading

CLASSIFICATION BASIS NATURE OF CONTRACT

Derivatives can be broadly classified into 2 types based on the nature of contract as can be seen from
the diagram below. All types of derivatives fall into either of these 2 categories:

Derivatives

Forward Contingent
Commitment Claim

Forwards Options

Futures Swaps

Swaps

Forward Commitment

These derivatives comprise of an assured occurrence in the future. The underlying asset will
get exchanged at a fixed future time, at a fixed price, agreed upon by both parties at the time of
entering into the contract. Since the exchange is fixed at a future time, it is called a Forward
Commitment. Neither party can back out of the contract once it has been entered into, except under
mutual consent. Futures, Forwards and Swaps are three main types of derivatives that fall under this
category. We will discuss each of these in detail in subsequent sessions.

Copyright © 2020 by NSE Academy

All rights reserved. No part of this publication shall be reproduced, distributed, or transmitted in any form or by any means, including photocopying,
recording, or other electronic or mechanical methods, without the prior written permission of NSE Academy, except in the case of brief quotations
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Contingent Claim

These derivatives comprise of an exchange subject to a certain event occurring at a future time. If the
event occurs, then the underlying asset will be exchanged at a fixed future time, at a fixed price, agreed
upon by both parties at the time of entering into the contract. Since the exchange is contingent on
the occurrence of an event, it is known as contingent claim. If the event does not occur, the
contract becomes null and void and will expire on the expiration date. Options and swaps come
under this category.

CLASSIFICATION BASIS UNDERLYING

Another way of classifying derivatives, is on the basis of the Underlying Asset. The types are as follows:

Type of Derivative Underlying Asset

Equity Stock / Share

Index Any broad-spectrum or sectoral index

Interest rate Debt instrument – loans / asset backed securities

Currency Foreign Exchange

Commodities Any commodity

CLASSIFICATION ON THE BASIS OF PLACE OF TRADE

Derivatives can either be traded over the counter (OTC) or on an organized exchange. Based on
the place of trade, they are called OTC derivatives and Exchange traded derivatives respectively.
Usually forwards, some types of options, swaps exotic products are OTC derivatives. Futures,
exchange-traded options are exchange traded derivatives.

Copyright © 2020 by NSE Academy

All rights reserved. No part of this publication shall be reproduced, distributed, or transmitted in any form or by any means, including photocopying,
recording, or other electronic or mechanical methods, without the prior written permission of NSE Academy, except in the case of brief quotations
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Over the Counter (OTC) Derivative Contracts

Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately
negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have the
following features compared to exchange-traded derivatives: (i) The management of counter-party
(credit) risk is decentralized and located within individual institutions, (ii) There are no formal
centralized limits on individual positions, leverage, or margining, (iii) There are no formal rules for risk
and burden-sharing, (iv) There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants, and (iv) The OTC
contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory
organization. They are however, affected indirectly by national legal systems, banking supervision and
market surveillance.

BASIC DERIVATIVES

Over the past couple of decades several exotic contracts have also emerged but these are largely
the variants of these basic contracts. Let us briefly define some of these abovementioned contracts.

Forward Contracts: These are promises to deliver an asset at a pre- determined date in future at a
predetermined price. Forwards are highly popular on currencies and interest rates. The contracts
are traded over the counter (i.e. outside the stock exchanges, directly between the two parties)
and are customized according to the needs of the parties. Since these contracts do not fall under
the purview of rules and regulations of an exchange, they generally suffer from counterparty risk i.e.
the risk that one of the parties to the contract may not fulfill his or her obligation.

Futures Contracts: A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in future at a certain price. These are basically exchange traded, standardized contracts.
The exchange stands guarantee to all transactions and counterparty risk is largely eliminated.

The buyers of futures contracts are considered having a long position whereas the sellers are
considered to be having a short position. It should be noted that this is similar to any asset market
where anybody who buys is long and the one who sells in short.

Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other
tradable assets. They are highly popular on stock indices, interest rates and foreign exchange.

Option Contracts: Options give the buyer (holder) a right but not an obligation to buy or sell an asset
in future. Options are of two types - calls and puts. Calls give 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. Puts
give 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. One can buy and sell each of the contracts. When one buys an option
he is said to be having a long position and when one sells he is said to be having a short position.

Copyright © 2020 by NSE Academy

All rights reserved. No part of this publication shall be reproduced, distributed, or transmitted in any form or by any means, including photocopying,
recording, or other electronic or mechanical methods, without the prior written permission of NSE Academy, except in the case of brief quotations
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It should be noted that, in the first two types of derivative contracts (forwards and futures) both
the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset to the seller
and the seller needs to deliver the asset to the buyer on the settlement date. In case of options
only the seller (also called option writer) is under an obligation and not the buyer (also called option
purchaser). The buyer has a right to buy (call options) or sell (put options) the asset from / to the
seller of the option but he may or may not exercise this right. In case the buyer of the option does
exercise his right, the seller of the option must fulfill whatever is his obligation (for a call option the
seller has to deliver the asset to the buyer of the option and for a put option the seller has to
receive the asset from the buyer of the option). An option can be exercised at the expiry of the
contract period (which is known as European option contract) or anytime up to the expiry of the
contract period (termed as American option contract).

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.

Copyright © 2020 by NSE Academy

All rights reserved. No part of this publication shall be reproduced, distributed, or transmitted in any form or by any means, including photocopying,
recording, or other electronic or mechanical methods, without the prior written permission of NSE Academy, except in the case of brief quotations
embodied in critical reviews and certain other noncommercial uses as permitted under copyright law.