Understanding Derivatives

Investors use financial instruments such as Derivatives & Futures to hedge risks. These risks can be financial liabilities, commodity price fluctuations or other factors. Financially stronger companies or share market dealers accept these risks and use various strategies to make profits out of it.

What are Derivatives?

In the investment industry, a ‘Derivative’ is a contract whose price is decided on the basis of one or more underlying assets. The underlying asset can be a currency, stock, commodity, or security(that bears interest). Sometimes, Derivatives are also used for trading in specific sectors such as foreign exchange, equity, treasury bills, electricity, weather, temperature, etc. For example, Derivatives for the energy market are called Energy Derivatives.

According to the Securities Contract (Regulation) Act, 1956 the term “derivative” includes :

A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

A contract that derives its value from the prices, or index of prices, of underlying Securities.

Types of Derivatives Contracts
Over the years, the types of derivatives contracts have evolved. The four basic types of Scottish Contracts are Futures, Options, Forwards, and Swaps.

1. Futures: A futures contract is a special type of forwarding contract where an agreement is made between two parties to buy or sell an asset at a particular price at a given time in the future.
2. Options: Options are contracts between an option writer and a buyer that give the buyer the right to buy/sell the underlying assets, other derivatives, etc. at a stated price on a given date. Here, the buyer pays the option premium to the option writer i.e the seller of the option. The option writer has to oblige if the buyer decides to exercise the right given through the options contract.
3. Forwards: It is a customized contract between two parties wherein the settlement happens on a specific date in the future at a price agreed upon on the contract date.
4. Swaps: Swaps are private contracts between two parties wherein an exchange of cash flows of the financial instruments owned by the parties takes place.

• The two commonly used swaps are:

1. Interest Rate Swaps: This involves swapping cash flows carrying interest in the same currency.
2. Currency Swaps: This allows the swap of cash flows with principal and interest in different currencies.