Types of Derivatives in the Market

2019/12/25

Derivatives are traded in four different types – Forwards, futures, options & swaps. Futures and forwards contracts can be explained together. Both these types of contract oblige the parties concerned to enter into a financial transaction on a future date or before the future date at a fixed price. Now what makes futures and forwards different is the basis of standardization. Futures contract are standardized contracts and hence traded on exchanges under the supervision of the clearing houses. Forward contracts are not standardized and hence are not regulated and are traded over the counter (OTC).

Swaps let you exchange an asset (or a liability) for another one. That is, in a swaps agreement two securities, or two interest rates or even two currencies are exchanged by the two parties for their personal benefits.

An options contract is quite different as it gives the owner the right but not the obligation to enter into a financial transaction on a future date or before the future date at a fixed price. Confusing right? The term important here is about giving the right but not the obligation. The owner of this contract has the right but not the obligation to buy (this is known as call option) or sell (known as put option) the asset from or to the other party. So an options contract lets you adjust with the market situation. But this benefit comes with a heavy risk tag.

An example of an option trading: A 1 acre of land is put for sale by Ms.Y in her town. Mr. X is a real estate investor who often invests in good projects. Mr. X’s close friend from the town where the land is located gives a piece of vital  information to Mr. X about the land. A Technology Park is planned to be constructed near the land of Ms. Y, though it is not confirmed yet. Now Mr. X knows that if the Technology Park plan goes ahead, the 1 acre land will be a golden investment. But if the plan is dropped, Ms. Y’s land is of no use to Mr. X. So what does Mr. X do?

He enters into an options contract with Ms. Y. The contract is – Mr X will pay Ms.Y an amount equal to $10,000, if Ms.Y promises not to sell her land to anyone for the next 4 months. During these 4 months Mr. X will get a clear knowledge about the Tech Park construction plans. If the plan goes ahead, Mr.X will pay a pre-specified amount to Ms.Y for the 1 acre of land (and later when the land price increases due to the nearby Tech Park, he can earn a high profit from re-sale). If the Tech Park plan is dropped, Mr.X will not buy Ms.Y’s land and Ms.Y can keep the $10,000 already given to her. This is an options contract where Mr.X has the right but not the obligation to buy the 1 acre of land.

Types of Derivatives in the Market personal-finance

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