Derivatives, as the name indicates are the financial instruments which derive their value from some other asset of monetary value called as “underlying asset”. This underlying asset can be gold, currency, stock or any commodity. In short, derivative is not an asset in itself but an agreement or a contract to transfer the real asset in future whenever exercised!! The date and price of execution is mentioned in the contract as per agreement between the parties. There are varieties of derivatives available at present like futures, options and swaps; futures and options being the most common ones. Before looking into details here are few components of a derivative agreement which need to be introduced first.
Holder
Holder is the buyer of derivative agreement. By buying an agreement, the buyer may agree to buy or sell the underlying asset.
Seller
One who sells the contract to holder.
Expiry date
The date at which agreement will get matured / exercised.
Strike price
The price at which derivative will get exercised and is decided at the time of entering into agreement (between buyer and seller).
Premium
It is the price which buyer pays for buying an option contract. The premium is not to be paid for futures contract.
The reason of its appeal to investors which makes it different than other financial instruments is that it is not an asset in itself but an agreement to convey the transfer of actual assets later in future. The catch here is why to enter an agreement to buy/sell assets in future?? Why not buy the real asset (underlying asset referred here) directly from spot market at current levels?? Why making an agreement to be executed in future date? The answer is; derivates are usually seen as instruments for bringing in protection against unexpected rise or fall in the price of underlying asset. Secondly, derivatives are used to yield better returns with lower capital investment as compared to the amount that will be invested to buy the shares directly form the spot market.
Types of derivative instruments
Forward Contract
It is an agreement to buy or sell the derivative at a known date in the future at a price decided as per negotiation between the contracting parties. These are not traded in exchanges.
Futures Contract
It is an agreement to buy or sell a financial instrument at a known date in the future at a price as per negotiation between contracting parties. These are traded on stock exchange.
Option Contract
It is a contract that gives holder the right, but not the obligation to exercise it. Call options give holder the right to buy while put option give the holder the right to sell at the strike price at stipulated date as per agreement.
Warrants
These are long term options having 3-7 years of expiration. Warrants are issued by companies for raising finance with no initial servicing costs like divided or interest. It is a type of security issued by corporation usually together with a bond or preferred stock that gives holder the right to buy a certain amount of common stock at a stated price. So it acts as a “sweetener offered along with the fixed-income securities”.
Swap Contract
Swaps are agreements between counterparties to exchange one set of financial obligations for another as per the terms of agreement.
Swaptions
Swaptions are options on swaps. They give holder the right to enter into having calls options and put options.