Trading in the derivatives market is almost similar to the experience of dealing in cash segments of the share market. But this type of trading needs a comprehensive insight into the stock market. Tracking the market movements and astute knowledge are the prime focuses of participants. Visit multibank group
Thus, not all traders can invest in derivatives. But what exactly are derivatives and their types? Spend a few worthy minutes reading the given narration and learn further.
An Introduction to Financial Derivatives
A derivative is a financial contract. It derives the value from the underlying asset. Its value gets linked to the underlying asset’s value. A buyer agrees to buy the asset at a specified price and date. Such assets can be bonds, currencies, commodities, stocks, etc. The underlying asset’s value changes with market movements.
A derivative contract’s prime motive is to anticipate the underlying asset prices. In addition, it guards against the commodity or asset’s price volatility. You may purchase the derivative contract with an accurate bet that leverage sits price movement. In short, derivative contracts are a cushion for the investment to limit huge losses.
Derivatives make a balanced exchange rate for the assets. Thus, they are a prominent option to hedge against price volatility. On this note, here are the types of financial derivatives.
4 Major Types of Financial Derivatives: What Are They?
Forwards or forward contracts do not trade on any exchange. The contracts trade over the counter (OTC). After creating the forward contract, a seller or buyer might personalize the size, settlement, and terms. Since they are OTC products, they have counterparty risks. Now, what are counterparty risks?
Simply put, these risks are the type of credit risk where parties might be incapable of living up to obligations outlined in a contract. When a party goes insolvent, another might not have any recourse. As a result, they may lose the position’s value.
As soon as it gets created, the parties in this contract offset the position with counterparties. With more traders getting involved in that contract, it increases the counterparty risks.
A futures or futures contract is a contract between two parties for an asset’s purchase & delivery. They get standardized contracts that trade on the exchange. The traders take advantage of a futures contract to hedge risks or anticipate on prices of the underlying asset. Parties here remain obligated to fulfil the commitment to sell or buy an underlying asset.
But note that not every futures contract gets settled at expiration by delivering that underlying asset. When both parties in the agreement anticipate traders or investors, either of them might wish to make contracts for the delivery of the asset. So, speculators may end the obligation to buy or deliver any underlying commodity by closing the agreement contract before its expiration.
A few derivatives remain cash-settled, meaning the loss or gain in the trade is the accounting cash flow to the trader’s brokerage account. Cash-settled futures contracts may include interest rate futures, unusual instruments like weather futures & volatility futures, stock index futures, etc.
Now, what are swaps? Put simply, they are derivative agreements that assist two parties in exchanging financial obligations. The fact is that corporates use swap contracts to hedge and mitigate the uncertainty risks of a few projects.
They are a common derivative type used to exchange one sort of cash flow with another. They can get constructed to exchange the currency-exchange rate risk or default risk on the cash flow or loan from different business activities. Swaps are available in four main types. And they are:
Interest Rate Swaps
This type of contractual agreement occurs between two parties for exchanging interest payments. One of the common interest rate swap types is the one that involves a party who agrees to make payments to another. The payment depends on the fixed interest rate. Note that the second party must agree to pay the first one depending on the floating interest rate in this type.
The currency swap is the contract. Here, two parties exchange the loan’s interest and principalamount in a single currency for the amount in another. But note that in the beginning, the equivalent principal amounts first get exchanged at a spot rate.
The commodity swap is another derivative contract. Here, two parties who agree to exchange the cash flows consider the underlying commodity’s price. This type of contract gets used for hedging against price swings in the market. The best examples are livestock, oil, etc.
Credit Default Swaps
CDS or credit default swap is the agreement between two parties. Here, one party buys protection from another against the losses from a borrower’s default for a particular span. So, CDS buyers make periodic payments to sellers until the credit matures on a defined date.
Amongst the four types, the most prominent one is the credit default swap or CDS. It offers insurance from a debt default. A buyer offers the premium payment to the seller. The seller pays the buyer the asset’s face value. Then, the seller achieves that asset’s possession.
This contract offers a buyer an opportunity to sell or buy something at a specific price before or on a specified date. A forward contract allows two parties to remain obligated to make a transaction on a defined date. Here, buyers have a choice to execute the options and purchase assets at a specific price. Below are its two types:
A call option is an agreement between a seller and buyer to buy a stock at a specific price until the defined date of expiration. A buyer has the right to exercise the call & buy stocks.
With a put option, buyers get the right to sell the stock at a defined price (strike price) within a specific time. But the put purchaser needs to pay the seller an amount, better known as a premium.
So, traders should understand these basic types of financial derivatives before investing.