Module IV
DERIVATIVES: CONCEPT AND TYPES
Meaning of Derivatives
A derivative is a financial instrument whose value is derived
from the value of an underlying asset such as stocks, bonds,
commodities, currencies, interest rates, or market indices.
They are used for hedging risks, speculation, and arbitrage
opportunities.
TYPES OF DERIVATIVES
There are four major types of derivatives:
Type Description
Forward Customized agreement between two parties to buy/sell an asset at a
Contracts predetermined price on a future date. Not traded on exchanges.
Futures Standardized contracts traded on exchanges to buy/sell assets at a specified
Contracts future date and price.
Contracts that give the buyer the right, but not the obligation, to buy/sell an
Options
asset at a specific price before/at a set date.
Agreements between two parties to exchange cash flows or other financial
Swaps
instruments over time.
FORWARD CONTRACTS
Meaning:
A Forward Contract is an agreement between two parties to
buy or sell an asset at a future date for a price agreed upon
today.
Characteristics:
• Customized (OTC – Over The Counter)
• No standardization
• Higher counterparty risk
• Used mainly for hedging in commodities, currencies, etc.
Example:
A wheat farmer enters a forward contract with a food
processing company to sell 1000 kg of wheat at ₹25/kg after 3
months.
FUTURES CONTRACTS
Meaning:
A Futures Contract is a standardized agreement traded on an
exchange to buy/sell an asset at a predetermined price and
date.
Features:
• Traded on organized exchanges (like NSE, BSE)
• Standardized contract terms
• Mark-to-market mechanism (daily settlement)
• Requires margin money
Example:
Buying a futures contract for 1,000 shares of Reliance
Industries at ₹2,800 per share with a 3-month expiry.
OPTIONS
Meaning:
An Option Contract gives the buyer the right, but not the
obligation, to buy or sell an asset at a fixed price within a
specific period.
Types:
1. Call Option – Right to buy the underlying asset.
2. Put Option – Right to sell the underlying asset.
Participants:
• Holder (Buyer): Pays premium; has the right.
• Writer (Seller): Receives premium; has the obligation.
Example:
You buy a call option on TCS at ₹3,500 with expiry in 1
month. If TCS rises to ₹3,800, you exercise the option and
profit from the price difference.
SWAPS
Meaning:
A Swap is a derivative contract in which two parties exchange
financial obligations, typically involving cash flows.
Common Types:
1. Interest Rate Swaps – Exchange fixed interest rate with
floating rate or vice versa.
2. Currency Swaps – Exchange cash flows in different
currencies.
Example:
Company A (India) and Company B (US) agree to swap loans
to reduce interest costs and hedge currency risk.
DERIVATIVES TRADING MECHANISM
1. Exchange-Traded Derivatives
• Traded on recognized exchanges like NSE, BSE, MCX
• Standardized contracts
• Regulated by SEBI
• Requires margin deposit
• Daily settlement (Mark-to-Market)
2. Over-the-Counter (OTC) Derivatives
• Privately negotiated between parties
• More flexible and customized
• Higher credit risk
• Less regulated
TRADING PROCESS IN EXCHANGE-TRADED
DERIVATIVES
1. Opening a Trading Account with a registered broker.
2. Placing Orders – Buy/sell futures or options via trading
platform.
3. Margin Requirements – Initial and maintenance
margins to cover risk.
4. Order Matching & Execution – Based on bid-ask in
exchange.
5. Mark-to-Market (MTM) – Daily profit/loss adjusted to
margin account.
6. Settlement:
o Cash Settlement (common in index derivatives)
o Physical Settlement (in some stock derivatives)
Conclusion
Derivatives are powerful financial tools used for risk
management and speculation. Understanding the nature of
contracts—forward, futures, options, and swaps—helps in
navigating financial markets efficiently. Regulatory oversight
by SEBI in India ensures transparency and protection for
investors in the derivatives market.