More about Derivatives: Different types of derivatives and their usesShashwat Mahaseth
Derivatives are financial instruments that enable the trading of risk from one party to the other. In case you need to gain the understanding of derivatives from first principles you can check out the article on derivatives. In this article, we will expand the idea on different kind of derivatives that exist and why they are needed.
Derivatives are one of the key factors that led to the growth of finance in the past four decades. They gave an elegant solution to transfer the risk without needing to transfer the underlying asset. With derivatives, it became possible to segregate the types of risk and trade any risk that the owner of the asset is not comfortable with. This trade-ability of risk led to exponential growth in finance as a sector and also provided a fillip to the world economy.
Size of the derivatives market
Ever wondered how big the derivatives market is? The Bank of International Settlements(BIS) puts the size on the notional value of US $650 trillion as on end of June 2017. The notional value of a derivatives contract is the value of the underlying assets of the derivatives contract. To put this number into perspective – the total size of the world economy is about (US $107.5 trillion), and the top 10 economies GDP is about US $55 Trillion.
Types of Derivatives
The derivatives can be classified into three different dimensions. Let’s look at each one of them and see why they are needed.
Derivatives based on how and where they are traded
The derivatives can be traded between two parties and can also be traded in a standardized way in the exchanges. These two types of derivatives are called Over the Counter(OTC), and Exchange Traded derivatives (ETD).
- Over the Counter(OTC) Derivatives
OTC derivatives are contracts that are made directly between the two parties. They are customized contracts suited to the needs of the two parties and it cannot normally be sold to a third party. These derivatives make up about the 80% of the derivatives market. According to BIS, the OTC derivative market size was $542 trillion on June 2017. The participants in the OTC derivative contracts are large financial institutions like Banks, Hedge Funds, etc. Derivative products like swaps, forward rate agreements, and exotic derivatives are typically OTC derivatives.
- Exchange Traded Derivatives (ETD)
The ETDs are standardized contracts that are traded on derivative exchanges/ stock exchanges. The terms of the contracts are standard and are defined by the exchange. The exchange is an intermediary to all ETDs and takes initial margin from both the buyer and the seller side of the trade to safeguard both parties. These are the types of derivatives an individual can trade in. If you have a valid DEMAT account, you can straightaway buy and sell such derivatives. Few examples of ETDs are equity derivatives, index derivatives etc.
Typically, the OTC derivatives that are used very frequently and in large volumes are taken by the exchanges, their terms and conditions are standardized, and they are introduced as tradable ETDs.
Derivatives based on the underlying asset class
Derivatives can be classified based on the underlying asset that they deal with. The assets can be financial instruments like equities, government bonds, physical assets like properties, etc. It can also be any risk factor that can that can be measured, and in certain cases it can be very exotic underlying like weather, economic indicators like unemployment rate, gross domestic product, etc.
Derivatives based on product characteristics
These types of derivatives differ regarding their dependence on the price of the underlying assets.
The main types of such derivatives are forwards, futures, options, and swaps.
This is a customized/ non-standardized contract between two parties. This is non-tradable to the third party. Typically, a forward contract pre-determines the price of the asset at a specific time in the future. You can find the example of a forward contract here.
Futures are same as forwards contract except for the part that they can be bought and sold in the exchanges. The futures contract is standardized by the exchange and can be bought and sold by any number of parties.
‘Options are contracts that give the owner the right, but not the obligation’, to buy or sell an asset at a particular price point within a time frame. The price point is known as the strike price. The maturity date is the final time till which an option can be exercised. Depending on whether the option allows you to buy or sell the asset.
- Call Option
This option lets the buyer of the call option BUY an agreed quantity of the underlying asset from the seller of the option on or before the maturity/expiration date at the strike price.
- Put Option
This option lets the buyer of the put option SELL and agreed on the quantity of the underlying asset to the seller of the put option on or before the maturity/expiration date at the strike price.
Both the call and put options are rights, not obligations.
In this type of derivatives, the buyer and the seller exchange the cash flows of one party’s financial instrument with the other party’s financial instrument on or before a specified future date.
The swaps can be based on any financial instrument like interest rates, currency exchange rates, etc. Swaps, therefore, can be used to hedge financial risks or speculate on the direction of price fluctuation of financial instruments like interest rates, currencies, stocks, bonds, etc.
Just like call and put options, swaps have swaptions, i.e., receiver and payer.
The buyer of the receiver swaption has the option to receive fixed cash flows in exchange of floating cash flows.
The buyer of the payer swaption has the option to receive floating cash flows in exchange of fixed cash flows.
As in the case of call and put options both receiver and payer swaptions are rights, not obligations.
While there are several types of swaps in the market, two of the most common types of swaps are Interest rate swaps and Currency swaps.
- Interest rate swap
The interest rate swap exchanges the interest associated cash flows in the same currency.
- Currency swap
In this type of swap, the two parties exchange the principal and interest in different currencies.
The several types of derivatives explained above are just the most common types of derivatives that exist. Apart from these, there are several types of derivatives that are used like warrants, binary options, Collateralized Debt Obligations (CDOs), etc. I will keep them their explanation and significance for another article.
If you want to embark on this fascinating journey of derivatives, you can view the webinar recording on “Derivatives-in-Action: Trading and Risk Management with Derivatives” by Mr. Amit Parakh on 27th June 2018, between 8:00 PM to 9:00 PM powered by Learno. Mr. Parakh is among the highly qualified global trainers in the financial training space. He has a B-Com from Calcutta University and an MBA from IIM Ahmedabad. He has aced Chartered Accountancy, FRM, CS, CFA® exams all in the first attempt and has mentored thousands of students in their careers in finance.