Common Derivatives

There are three basic types of derivative contracts. These include options, swaps, and futures/forward contracts. All three have many variations.

Forward Contracts

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 between these transactions. Hence, there is an increased chance of counterparty credit risk. Also, before the internet age, finding an interesting 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.

Futures Contracts

A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodities at a future date 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. The buyer and seller do not enter into an agreement with one another. Rather, both of them enter into an agreement with the exchange. Hence, these contracts are of standard nature and the agreement cannot be modified in any way.

Exchange contracts come in a pre-decided format, and 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.

Option Contracts

The third type of derivative i.e. option is markedly different from the first two types. In the first two types, both 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. A call option allows you the right but not the obligation to buy something at a later date at a given price whereas a 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

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 that are negotiated between two parties. Usually, investment bankers act as middlemen in 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.