What is the derivative market?
It is a type of financial market where different types of derivatives are traded. Derivatives are financial instruments whose value is derived from and depends on underlying assets. The common underlying assets used are stocks, bonds, currencies, commodities, market indexes, etc. Derivative’s value comes from the fluctuation in the value of underlying assets. They are a contract between two parties to buy or sell these underlying assets.
These contracts can be traded on two platforms. First is over the counter where a contract is a non-standardized contract which is privately negotiated between the two parties involved. The second way to trade derivatives is through regulated exchange market where a contract is a standardized contract, in this exchange acts as an intermediary, which helps the trader to avoid counterparty risk which often appears in over the counter market.
Different types of derivative contracts
1. Forward contracts – It is a contract between two parties in which the buyer and the seller are obligated to buy and sell a certain asset at a specific price within a particular time. These contracts are not standardized and are mostly traded on over the counter market instead of an exchange. Therefore, they bear more credit risk as there is no intermediary involved that guarantees transaction. Counterparty risk is high in these contracts. The two counterparties themselves negotiate and agree on the exact terms of the contract such as settlement price, date, units of underlying assets, etc. Forward contracts settle just once at the end of the contract.
2. Future contracts – It is a contract which involves an agreement to buy or sell an asset at a specific price on a specific date. It is evolved out of forwarding contract, therefore, has a few similarities but also has some differences such as future contract are subject to daily settlements which means daily changes in price can be settled day by day until the end of the contract. They are standardized contracts which are traded on an exchange; therefore, counterparty risk is not much a problem here. It is a highly liquid market which allows the traders to enter and exit whenever they wish to do. Most contracts are closed out prior to its maturity time.
3. Options contract – It is a contract between the buyer and the seller of a particular asset which gives the buyer the right but not obligation to buy or sell the particular asset at a specific price for a particular period of time but obligates the seller to meet the terms of delivery if the contract’s rights are being exercised by the buyer. There are two ways by which options contracts can be traded:-
- Call option – It is bought if the trader is expecting the price of the underlying asset to rise or bullish towards it.
- Put option – It is bought if the trader is expecting the price of the underlying asset to fall or bearish towards it. Puts and calls can also be sold which will be discussed in the further sections. Every options strategy is based on buying and selling calls and puts.
4. Swap contracts – It is a contract between two parties through which they exchange their one kind of cash flow with another, for example, interest rate swap, in which two counterparties agree to exchange one stream of future interest payment for another, based on the specific principal amount. It mostly includes the exchange of a fixed interest rate for a floating rate. Swaps are traded over the counter and are mostly used by businesses, financial institutions, etc, to hedge various kinds of risks like interest rate risks, currency risk, etc.