Understanding Derivatives and its Types

Financial Derivatives are contracts whose worth is derived from the movement of an underlying asset, index, or rate. These contracts can be used for various purposes, including hedging against risks, speculating on price movements, or arbitrage opportunities. In simpler terms, a derivative's worth depends on the value of something else, which could be stocks, bonds, commodities, interest rates, or even market indices.

Derivatives are traded on stock exchanges like NSE, BSE, etc. and the over-the-counter (OTC) market.

1. Futures contracts

Futures contracts are standardised agreements between two parties to buy or sell an underlying asset at a pre-agreed price on a specified date. These contracts are traded on exchanges, which standardise their terms, including lot size and expiration date.

Credit risk is minimal with futures contracts because they are settled through clearing houses, which guarantee the transaction by acting as the counterparty for both sides.

Futures can be based on underlying assets, such as stocks, commodities, or currencies.

Common examples of futures contracts include Nifty Futures and Bank Nifty Futures, regulated by the NSE. For instance, Nifty Futures has a standard lot size of 50 units, and each contract expires at the end of its designated month.

2. Forwards contracts

A forward contract is similar to a futures contract but differs in several ways. Unlike futures contracts, which are traded on exchanges, forward contracts are traded over-the-counter (OTC) and offer greater flexibility.

Forward contracts can be customised to fit the specific needs of both parties involved. There are no standard lot sizes or set expiration dates; the terms, including quantity and settlement date, are negotiated directly between the counterparties.

However, forward contracts do not involve clearinghouses, so they carry a higher credit risk than futures contracts. Retail investors typically do not trade forwards; corporations and financial institutions more commonly use these contracts for tailored financial needs.

3. Swaps

A swap is a derivative contract that enables the exchange of future cash flows between the two parties engaged in the agreement. Swaps are used for safeguarding against the risk of credit default via a Credit Default Swap (CDS).

Interest Rate Swaps (IRS) and Foreign Exchange Swaps (FX Swaps) are the most commonly used swap agreements. They are traded on the OTC market and are usually not dealt with by retail traders/investors.

4. Options contracts

An option contract gives the parties involved a right but not an obligation to buy/sell the underlying assets at a predetermined date in the future for a specified price. The most crucial element of this agreement is that it only gives you the right to conduct a transaction but does not make it necessary for you to indulge in it.

The buyer of an options contract pays the associated premium (the price at which the option is trading) and gets the right to buy the underlying security from the seller, who will be obligated to sell the security, provided the buyer exercises their right.

Options are widely traded on exchanges and in the OTC market. They are used for both hedging and speculation purposes and are available in two types.

• Call option: The call option gives the buyer the right to buy the underlying security from the seller at a predefined price on the date of settlement/expiry. Traders usually buy call options when they expect the underlying security's price to rise in the future or to hedge against such an increase in prices.
  

• Put option: This options contract gives the buyer the right to sell the underlying asset at a predefined price on the maturity date of such a contract. Traders usually buy put options when they expect the underlying security's price to decline in the future or to hedge against such a decrease in prices.

Underlying asset price

In all derivatives contracts, the underlying asset's price relative to the option's strike price is crucial in determining the option's value. For call options, if the underlying asset's price is higher than the strike price, the option's value generally increases. Conversely, for put options, the value tends to rise when the underlying asset's price falls below the strike price.

Time

What sets option contracts apart from other derivatives is their pricing, which is significantly influenced by the time remaining until expiration. The more time left, the higher the option's premium. As the expiry date approaches, the option's price generally decreases, assuming other factors remain unchanged.

Volatility

In scenarios where the underlying asset's price displays volatility, the pricing of its associated options contracts tends to be higher. This is because the likelihood of attaining the desired underlying price is higher compared to a stable market environment.

Interest rates

The interest rate is used for discounting the future cash flows of the option back to the present value. Hence, it fluctuates the price of an options contract.

Derivatives are a powerful financial instrument that, if appropriately devised, can help you hedge your portfolio and scale up your returns.

To use derivatives in your favour, you need a suitable Demat Account. That is where the HDFC Bank Demat Account can help you. It allows you to transact in equities, derivatives,ves and other products.

But, as with any other security, derivatives are also subject to market risk, and you should indulge in them only after acquiring proper knowledge.

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*Terms and conditions apply. This is an information communication from HDFC Bank and should not be considered as a suggestion for investment. Investments in the securities market are subject to market risks; read all the related documents carefully before investing.