Derivatives are powerful, useful, and rewarding financial instruments used by a huge chunk of investors in the market. Derivatives can be used for a variety of purposes, and there are also a variety of kinds of derivatives.
In this article, we will talk about the Financial Services four most common kinds of derivatives. See if you’d like to try any one of them.
Forwards contracts are the simplest form of derivatives, being the first invented derivative contract in the history of financial markets. That means it’s also the oldest form of derivatives.
A forward contract is simply a deal wherein an asset will be sold on a predetermined future date. Meanwhile, the parties involved in the agreement will determine the sale price at the present.
Forwards contracts exist between two counterparties, meaning there’s no exchange to act as an intermediary between the two engaged parties. This means that in case you try out forwards contracts, you incur higher counterparty risks.
In addition to that, sometimes the contracts need to be reversed before they expire. In that case, the terms of the contract may be unfavourable to the parties.
A futures contract can be very similar to forwards contracts in a way that it also allows the parties to sell assets at a future set date and determine the price at the present.
The distinction lies on the fact that futures are traded on an exchange, which in this case can actually serve as an intermediary.
Futures are Funding Methods standardized, meaning you cannot modify the contract in any way, since they are under strict formats, sizes, expirations. They are also under a rule of a daily settlement procedure, in which any gains or losses should be settled within the trading day. This rule wipes out the counterparty credit risk.
Therefore, the parties in a futures contract are bound by their agreement with the exchange, not by each other.
Options contracts are very distinctive from the first two. For one, forwards and futures bind the parties to the rules of the agreement, requiring them to fulfil their duties to the contracts. Options contracts, on the other hand, binds only one party. The other party, then, only has the choice to push through the contract on a certain date and price.
In other words, once the options contract expires, one party has the right to buy or sell the underlying asset, but is not obligated to do so, hence the name “options.”
There are 2 kinds of options contracts: the call option and the put option. Call options enable you to buy an asset at a future date without having to do it if you don’t feel like to. Put options, on the other hand, allows you to sell an asset at a future date, but not the obligation to push through.
Other kinds of Derivatives
There are other kinds of derivatives, usually coming from the combination of two or more of those derivatives mentioned above. Some examples of other derivatives are contract for differences (CFDs) and swaps.