types Of derivatives

 Definitions of Basic Derivatives

There are various types of derivatives traded on exchanges across the world. They range from

the very simple to the most complex products. The following are the three basic forms of

derivatives, which are the building blocks for many complex derivatives instruments (the latter

are beyond the scope of this book):

· Forwards

· Futures

· Options

Knowledge of these instruments is necessary in order to understand the basics of derivatives.

We shall now discuss each of them in detail.

Forwards

A forward contract or simply aforward is a contract between two parties to buy or sell an

asset at a certain future date for a certain price that is pre-decided on the date of the contract.

The future date is referred to as expiry date and the pre-decided price is referred to as Forward

Price. It may be noted that Forwards are private contracts and their terms are determined by

the parties involved.

A forward is thus an agreement between two parties in which one party, the buyer, enters into

an agreement with the other party, the seller that he would buy from the seller an underlying

asset on the expiry date at the forward price. Therefore, it is a commitment by both the parties

to engage in a transaction at a later date with the price set in advance. This is different from

a spot market contract, which involves immediate payment and immediate transfer of asset.

The party that agrees to buy the asset on a future date is referred to as a long investor and is

said to have a long position. Similarly the party that agrees to sell the asset in a future date is

referred to as a short investor and is said to have a short position. The price agreed upon is

called the delivery price or the Forward Price.

Forward contracts are traded only in Over the Counter (OTC) market and not in stock

exchanges. OTC market is a private market where individuals/institutions can trade through

negotiations on a one to one basis.

Settlement of forward contracts

When a forward contract expires, there are two alternate arrangements possible to settle the

obligation of the parties: physical settlement and cash settlement. Both types of settlements

happen on the expiry date and are given below.

Physical Settlement

A forward contract can be settled by the physical delivery of the underlying asset by a short

investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed

forward price by the buyer to the seller on the agreed settlement date. The following example

will help us understand the physical settlement process.

Illustration

Consider two parties (A and B) enter into a forward contract on 1 August, 2009 where, A agrees

to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 per share, on 29 th August, 2009

(the expiry date). In this contract, A, who has committed to sell 1000 stocks of Unitech at Rs.

100 per share on 29th August, 2009 has a short position and B, who has committed to buy 1000

stocks at Rs. 100 per share is said to have a long position.

In case of physical settlement, on 29th August, 2009 (expiry date), A has to actually deliver

1000 Unitech shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 10,000) to A. In

case A does not have 1000 shares to deliver on 29th August, 2009, he has to purchase it from

the spot market and then deliver the stocks to B.

On the expiry date the profit/loss for each party depends on the settlement price, that is, the

closing price in the spot market on 29th August, 2009. The closing price on any given day is the

weighted average price of the underlying during the last half an hour of trading in that day.

Depending on the closing price, three different scenarios of profit/loss are possible for each

party. They are as follows:

Scenario I. Closing spot price on 29 August, 2009 (S T) is greater than the Forward price (FT )

Assume that the closing price of Unitech on the settlement date 29 August, 2009 is Rs. 105.

Since the short investor has sold Unitech at Rs. 100 in the Forward market on 1 August, 2009,

he can buy 1000 Unitech shares at Rs. 105 from the market and deliver them to the long

investor. Therefore the person who has a short position makes a loss of (100 – 105) X 1000 =

Rs. 5000. If the long investor sells the shares in the spot market immediately after receiving

them, he would make an equivalent profit of (105 – 100) X 1000 = Rs. 5000.

Futures

Like a forward contract, a futures contract is an agreement between two parties in which the

buyer agrees to buy an underlying asset from the seller, at a future date at a price that is

agreed upon today. However, unlike a forward contract, a futures contract is not a private

transaction but gets traded on a recognized stock exchange. In addition, a futures contract is

standardized by the exchange. All the terms, other than the price, are set by the stock

exchange (rather than by individual parties as in the case of a forward contract). Als o, both

buyer and seller of the futures contracts are protected against the counter party risk by an

entity called the Clearing Corporation. The Clearing Corporation provides this guarantee to

ensure that the buyer or the seller of a futures contract does not suffer as a result of the

counter party defaulting on its obligation. In case one of the parties defaults, the Clearing

Corporation steps in to fulfill the obligation of this party, so that the other party does not suffer

due to non-fulfillment of the contract. To be able to guarantee the fulfillment of the obligations

under the contract, the Clearing Corporation holds an amount as a security from both the

parties. This amount is called the Margin money and can be in the form of cash or other

financial assets. Also, since the futures contracts are traded on the stock exchanges, the parties

have the flexibility of closing out the contract prior to the maturity by squaring off the

transactions in the market.

    Difference between forwards and futures

Forwards Futures

Privately negotiated contracts Traded on an exchange

Not standardized Standardized contracts

Settlement dates can be set by the parties

Fixed settlement dates as declared by the

exchange

High counter party risk Almost no counter party risk

Options

Like forwards and futures, options are derivative instruments that provide the opportunity to

buy or sell an underlying asset on a future date.

An option is a derivative contract between a buyer and a seller, where one party (say First

Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or

sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price.

In return for granting the option, the party granting the option collects a payment from the

other party. This payment collected is called the “premium” or price of the option.

The right to buy or sell is held by the “option buyer” (also called the option holder); the party

granting the right is the “option seller” or “option writer”. Unlike forwards and futures contracts,

options require a cash payment (called the premium) upfront from the option buyer to the

option seller. This payment is called option premium or option price. Options can be traded

either on the stock exchange or in over the counter (OTC) markets. Options traded on the

exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to

default by the counter parties involved. Options traded in the OTC market however are not

backed by the Clearing Corporation.

There are two types of options—call options and put options

Call option

A call option is an option granting the right to the buyer of the option to buy the underlying

asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller

who grants this right to the buyer of the option. It may be noted that the person who has the

right to buy the underlying asset is known as the “buyer of the call option”. The price at which

the buyer has the right to buy the asset is agreed upon at the time of entering the contract.

This price is known as the strike price of the contract (call option strike price in this case). Since

the buyer of the call option has the right (but no obligation) to buy the underlying asset, he will

exercise his right to buy the underlying asset if and only if the price of the underlying

asset in the market is more than the strike price on or before the expiry date of the

contract. The buyer of the call option does not have an obligation to buy if he does not want

to.

Put option

A put option is a contract granting the right to the buyer of the option to sell the underlying

asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is

the seller who grants this right to the buyer of the option. The person who has the right to sell

the underlying asset is known as the “buyer of the put option”. The price at which the buyer

has the right to sell the asset is agreed upon at the time of entering the contract. This price is

known as the strike price of the contract (put option strike price in this case). Since the buyer

of the put option has the right (but not the obligation) to sell the underlying asset, he will

exercise his right to sell the underlying asset if and only if the price of the underlying

asset in the market is less than the strike price on or before the expiry date of the

contract. The buyer of the put option does not have the obligation to sell if he does not want

to.