Link Between Blockchain and Cryptocurrency
When a new investor enters the world of cryptocurrency, they often use two terms mentioned together. These two terms are “cryptocurrencies” and “blockchain”. The two terms are used together so often that it gives many investors the idea that they both mean the same thing. This is particularly true if the investors are not tech-savvy. […]
Red Flags that Investors Need to Look out for in Term Sheet
First-time investors are quite anxious to raise funding for their projects. The fact that professional investors are looking to invest in their projects can be quite overwhelming for some founders. As a result, it is common for these founders to believe that the investors are acting in good faith. Often, this means that the investors […]
The Need for Derivatives
In the previous article, we discussed as to how derivatives contracts can be dangerous and can pose a systemic risk. Then the question arises as to why are derivates needed at all? If they are dangerous financial instruments, that can pose a risk to the safety of the entire financial universe, then why is it […]
Exchange Rate Regimes
International trade is a vital component of the economy of any nation. Also, international trade is highly dependent upon exchange rates. It is for this reason that the choice of the type of exchange rate regimes is very important. To a layman, all exchange rate regimes might appear to be similar. However, the reality is […]
Capital Adequacy Ratio – Meaning and its Importance
Banks in the modern world face an inherent risk of insolvency. Since the banks are so highly leveraged, there could be a run on the bank any moment if their reserves are considered to be inadequate by the market. Hence, banks must maintain adequate capital in their vaults if they want to survive. However, what […]
In the previous articles we discussed about what derivative contracts are and what are the uses of such contracts? However, one important point needs to be noticed. Today, if a new person wants to buy a derivative contract, they will be bewildered at the sheer amount of choice that they will have at their disposal. There are hundreds or even thousands of types of contracts that are available in the market. This may make it seem like a difficult and confusing task to deal with derivatives. However, that is not the case. True, that there are hundreds of variations in the market. However, these variations can all be traced back to one of the four categories. These four categories are what we call the 4 basic types of derivative contracts. In this article, we will list down and explain those 4 types:
Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.
However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favorable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.
A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present.
However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.
An important point that needs to be mentioned is that in case of a futures contract, they buyer and seller do not enter into an agreement with one another. Rather both of them enter into an agreement with the exchange.
The third type of derivative i.e. option is markedly different from the first two types. In the first two types both the parties were bound by the contract to discharge a certain duty (buy or sell) at a certain date. The options contract, on the other hand is asymmetrical. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.
There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price. Any individual therefore has 4 options when they buy an options contract. They can be on the long side or the short side of either the put or call option. Like futures, options are also traded on the exchange.
Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well.
Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are usually not traded on the exchange. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a large amount of exchange rate risks.
So, these are the 4 basic types of derivatives. Modern derivative contracts include countless combinations of these 4 basic types and result in the creation of extremely complex contracts.
Your email address will not be published. Required fields are marked *
