Derivatives – Forwards, Futures, Options & Swaps

Introduction

A Derivative is a contract whose value is "derived" from the value of an underlying asset (Stock, Index, Gold, Currency).

1. Types of Derivatives

A. Forwards (OTC)

• Customized contract between two parties to buy/sell at a future date.
• Risk: Counterparty risk (Other party may run away).
• Traded: Over-the-counter (Not on Exchange).

B. Futures (Exchange Traded)

• Standardized version of Forwards.
• Traded: On Stock Exchange (NSE).
• Risk: No counterparty risk (Clearing House guarantees trade).

C. Options

Right, but not the obligation, to buy/sell.

• Call Option: Right to BUY. (Bullish view).
• Put Option: Right to SELL. (Bearish view).
• Premium: Cost paid to buy the option.

D. Swaps

• Agreement to exchange cash flows.
• Interest Rate Swap: Swapping Fixed Interest payments for Floating Interest payments.

2. Uses

• Hedging: Insurance against price movement.
• Speculation: Betting on price direction.
• Arbitrage: Profiting from price difference in two markets.

Summary

• Derived Value: Depends on Underlying.
• Forward: Customized, Risky.
• Future: Standardized, Safe (Exchange).
• Option: Right, not obligation.

Quiz Time! 🎯

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