Classification of Derivatives – Forward, Futures, Options, Swaps
The Derivatives family has 4 main members.
1. Classification by Market
Over-The-Counter (OTC)
- Customized contracts.
- Traded directly between two parties (e.g., Bank and Company).
- Examples: Forwards, Swaps.
- Risk: Counterparty Default Risk exists.
VS
Exchange Traded (ETD)
- Standardized contracts.
- Traded on Stock Exchange (NSE/BSE).
- Examples: Futures, Options.
- Risk: Zero Default Risk (Exchange guarantees).
2. The Big 4 Instruments
- Forwards: Agreement to buy/sell at future date. (Customized).
- Futures: Same as Forward, but Standardized and Traded on Exchange.
- Options: Gives the Right (but not obligation) to buy/sell. (Like Insurance).
- Swaps: Agreement to Exchange cash flows (e.g., Fixed Interest vs Floating Interest).
3. Diagram: The Family Tree
Derivatives"Root"
↓
Branch 1: OTC"Forward, Swaps"
↓
Branch 2: Exchange Traded"Futures, Options"
4. Exam Notes: Writing the Answer
Question: "Classify Financial Derivatives." (10 Marks)
Answering Strategy:
- Tree Diagram: Draw the Market-based classification (OTC vs Exchange).
- Define Each: Write 2 lines for each of the 4 types (Forward, Future, Option, Swap).
- Key Distinction: Emphasize "Obligation" (Forward/Future/Swap) vs "Right" (Option).
Summary
- Evolution: It started with Forwards (simple), moved to Futures (safe), then Options (flexible), and Swaps (complex).
Quiz Time! 🎯
Test Your Knowledge
Question 1 of 4
1. Which of the following is an Exchange Traded Derivative?