Types of Derivatives

Rajesh, now familiar with futures contracts, decided to explore other types of derivatives to manage different risks. Through his research, he discovered four primary types of derivatives: forwards, futures, options, and swaps. Let’s take a closer look at these instruments, focusing on futures and options, which are the most commonly used derivatives in India.

Forward Contracts

Forward contracts are private agreements between two parties to buy or sell an asset at a predetermined price on a future date. Key characteristics include:

• Customisation: Forward contracts are tailored to meet the needs of the parties involved.
  
• OTC Nature: These are over-the-counter (OTC) agreements, not traded on exchanges.
  
• Counterparty Risk: Since these contracts are private, they carry a higher risk of default.
  

While forward contracts offer flexibility, Rajesh learned they are less liquid and harder to trade than exchange-traded instruments like futures.

Futures Contracts

Futures are standardised contracts traded on exchanges like the National Stock Exchange (NSE). They obligate the buyer and seller to transact at a predetermined price on a future date. Futures stand out for their:

• Liquidity: They are easier to trade due to their standardisation.
  
• Daily Mark-to-Market: Profits and losses are settled daily, reducing the risk of default.
  

Rajesh found that futures contracts are widely used to hedge against price fluctuations in various markets, including:

• Commodities: Agriculture, energy, and precious metals.
  
• Equities: Stock indices like the Nifty 50.
  

India’s Futures Market

The NSE is the world’s largest derivatives exchange by traded contracts, averaging 6.39 billion traded contracts in 2023. This success is attributed to rising retail investor participation and better access through digital platforms.

Options Contracts

Options provide the buyer with the right, but not the obligation, to buy or sell an asset at a specified price within a defined timeframe. They can be compared to insurance policies:

• The buyer pays a premium for this right.
  
• If the market moves favourably, the buyer can exercise the option; otherwise, the loss is limited to the premium paid.
  

Types of Options

1. Call Options: The right to buy an asset.
   

• Example: Rajesh could buy a call option to lock in a wheat price, anticipating a price increase.
  

2. Put Options: The right to sell an asset.
   

• Example: Rajesh could buy a put option to protect against a fall in gold prices.
  

Options are highly versatile and can be used across markets, including equities, commodities, and indices.

Futures vs. Options in Risk Management

Both futures and options are valuable tools for managing price risks:

• Futures lock in prices, ensuring stability against volatility.
  
• Options act as insurance, protecting against adverse price movements while offering flexibility.
  

Example

If Rajesh wanted to hedge against potential losses in his gold trading:

• A futures contract would fix the selling price for gold in advance.
  
• A put option would allow him to sell gold at a set price, protecting against a market downturn.
  

Derivatives in India

In India, the NSE and Bombay Stock Exchange (BSE) are the leading platforms for trading futures and options.

• Equity Derivatives: Instruments like Nifty 50 futures and options are among the most actively traded.
  
• Commodities Derivatives: Popular commodities include gold, silver, and crude oil.
  

These exchanges offer opportunities for traders, investors, and businesses to hedge risks and manage market volatility effectively.

Conclusion

Through his exploration, Rajesh gained a solid understanding of derivatives:

• Forward contracts offered flexibility but lacked liquidity.
  
• Futures contracts provided an efficient way to hedge against price fluctuations.
  
• Options acted as insurance, offering a balance between risk and reward.
  

Both futures and options equipped Rajesh with tools to navigate a volatile market and protect his investments.

In the next chapter, we will explore the key terminology and concepts in derivatives, helping you understand their mechanics and navigate this financial tool with confidence. Happy Learning!