A derivative is a financial contract between two or more parties whose value is derived from an underlying asset or a benchmark. The underlying asset can be a stock, a commodity (like gold or oil), a currency, or even an interest rate.
Think of a derivative as a bet on the future price of something else. You are not buying the asset itself, but a contract whose value depends on the price of that asset.
Types of Derivative Contracts
There are four main types of derivatives:
1. Forwards
A private, customised contract between two parties to buy or sell an asset at a specified price on a future date.
- Key Feature: It is traded over-the-counter (OTC) and is not standardised.
2. Futures
A standardised contract, traded on a stock exchange, to buy or sell an asset at a predetermined price on a specified future date.
- Key Difference from Forwards: Futures are standardised and traded on an exchange, which eliminates counterparty risk.
- Example: A farmer can enter into a futures contract to sell his wheat at a fixed price in three months, protecting him from a potential fall in wheat prices.
3. Options
A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (the “strike price”) on or before a certain date.
- Key Feature: The buyer has the right but not the duty to execute the contract. For this right, the buyer pays a premium to the seller.
- Types:
- Call Option: Gives the right to buy.
- Put Option: Gives the right to sell.
4. Swaps
A contract where two parties agree to exchange financial instruments or cash flows for a certain period. The most common type is an Interest Rate Swap, where one party agrees to pay a fixed interest rate in exchange for receiving a floating interest rate from the other party.
Purpose of the Derivatives Market
The two main purposes of using derivatives are:
- Hedging (Risk Management): This is the primary purpose. Hedging is a strategy to reduce the risk of losses from adverse price movements. For example, an airline company can use a futures contract to lock in the price of jet fuel, protecting it from a future price hike.
- Speculation: This involves taking on risk to make a profit. Speculators bet on the future direction of an asset’s price. For example, a trader who believes the price of a stock will go up can buy a call option to profit from that increase.
In India, the derivatives market is regulated by SEBI, and most of the trading happens on the National Stock Exchange (NSE).