Types of Derivatives

Derivatives in the present context are financial products that derive their value from the value of other financial assets. Financial options and future are the common examples, interest and currency swaps are also coming up.

All three: options, futures and swaps are contracts. Being contracts, they were not traditionally traded on exchanges, although in recent times an exception is made for some standardized options and futures contracts and options and futures exchanges now operate in some countries. This is not in the case of swaps, which are still largely bought and sold Over the Counter.

Options: A call option gives the buyer or owner of it the right, but does not impose on it a duty to buy from the seller or writer of the option the underlying asset (bonds or shares) at the agreed striking price during the time of the option (assuming that the option is an American type which can be exercised at any time, which is now the more common type everywhere). A put option gives the option holder the right to sell this asset to the writer of the option at an agreed price (the striking price) during the time of the option. By writing a call or put, the writer exposes himself to the option being exercised against him at the agreed price and gets paid a price or premium for his risk.

Futures: The futures contract is an agreement to buy or sell an asset at an agreed future time for a fixed price, often the present market price (or relevant index). By entering into a futures contract, both parties acquire rights and obligations in the nature of an ordinary sales contract. The difference is that the delivery of the goods and payment will be delayed until a future date.

Forwards: The difference between futures and forward contracts is that futures are traded on an exchange (as opposed to a forward which is an Over the Counter derivative).

Swaps: Swaps are the other traditional examples of derivatives. The term ‘swap’ by itself does not denote a particular legal structure except some kind of an exchange. It is common to find an exchange of accruing cash flows, normally resulting from different interest rates (fixed or floating) structures. The result is an interest rate swap. They could also be in different currencies (currency swap).

Foreign exchange swap or a Forex swap or a FX swap: Forex swap is an exchange of identical amounts of one currency for another at a certain rate and for a certain time in the future. It thus helps to eliminate the risks involved with fluctuating foreign exchange rates.

Asset Swaps:  Asset swap is an exchange of tangible assets for intangible assets or vice versa and would help to change the character of the assets held by an entity depending on his requirements. As an example, a company may sell equity and receive the value in cash thus increasing liquidity.

Swaptions: Swaptions are similar to options; however instead of exercising an option to acquire or dispose of an asset, the option would be exercised in relation to a swap. A swaption may also be cash settled and in this case the seller would have to pay a sum equal to the market value of the swap on the exercise date. 

Caps, Floors and Collars: The above are the main type of derivatives contracts from which related products are derived. A variation in an interest rate swap is an interest rate cap. A cap is a transaction under which one party agrees to pay a floating rate to the other if the rate exceeds a specified level. Just as there are caps, there are also floors and collars. A floor, in contrast with a cap is a transaction under which one party agrees to pay a floating rate to the other if the rate is less than a specified level, so that it is protected against the risk of the rate falling below this level. A collar involves both the sale of a cap and the purchase of a floor. Under such a contract, one party agrees to pay a floating rate to the other if the rate is less than another lower level.