Different Types Of Derivatives in Share Market

Derivatives have recently become essential tools for managing risks and enhancing investment opportunities. These financial instruments are complex and can seem challenging to those unfamiliar with them.

With an increasing number of derivatives now available in the market, it is crucial for investors and financial professionals to understand its functioning, characteristics, and uses. Let us explore the different types of derivatives in India and shed light on everything you need to know about these financial instruments.

Topics Covered:

• What are Derivatives?
• Types of Derivatives in India
• Conclusion

What are Derivatives?

In finance, derivatives refer to financial instruments whose value is derived from an underlying asset or group of assets. These assets include commodities , stocks, currencies, bonds, and market indices. The basic concept of derivatives lies in their value being derived from the underlying asset's price movements rather than having intrinsic value.

One key aspect of derivatives is their role in risk management. Using derivatives, investors can hedge against potential losses by taking positions that offset the risks associated with their existing investments. This allows for effective risk management and can help protect against adverse market movements.

Additionally, derivatives and its types offer opportunities for speculation and investment strategies. Traders can use derivatives to speculate on the future price movements of the underlying assets, aiming to profit from market fluctuations. 

Furthermore, derivatives provide a means for investors to diversify their portfolios, as they offer exposure to different asset classes and markets.

Types of Derivatives in India

Within the Indian financial market, there are various derivatives types that investors can utilise to manage risk, speculate on price movements, and enhance investment strategies. Two prominent and widely traded types of derivatives in India are futures and options.

1. Futures

   Futures contracts are a popular type of derivative in India. These contracts allow buyers and sellers to agree on purchasing or selling an underlying asset, such as commodities, stocks, or currencies , at a predetermined future date and price.

   By entering into a futures contract, both parties commit to fulfilling the transaction on the specified date, regardless of the prevailing market price. This provides price certainty and allows investors to hedge against potential losses or take advantage of anticipated market movements. Futures contracts are used extensively in Indian commodity exchanges, where commodities like gold, silver, crude oil, and agricultural products are traded.

2. Options

   Options contracts offer the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified period. 

   These are categorised into two types: call options and put options. A call option gives the holder the right to buy the underlying asset, while a put option grants the holder the right to sell the asset. The buyer of an option pays a premium to the seller for this right.

   Options provide flexibility for investors, as they can be used for hedging purposes, speculation, or generating income through writing options. In India, options are traded on various underlying assets on recognised stock exchanges, including stocks, stock indices, and currencies.

3. Swaps

   Swaps are another important type of derivative in finance. These are agreements between two parties to exchange financial instruments or cash flows over a specified period. These agreements manage interest rates, currency, or credit risks.

   In a swap transaction, the parties agree to exchange the cash flows or values associated with different financial instruments, such as interest payments on loans or the exchange rate between two currencies.

   Swaps can be customised to suit the parties' specific needs, allowing them to tailor the terms and conditions to their individual requirements. With their flexibility and ability to mitigate risk, swaps play a significant role in the global financial markets.(Get more information about  what is swaps )  

4. Forwards

   Another type of derivative is forwards, customised contracts similar to futures but lack standardisation. Unlike futures contracts, forwards are tailor-made agreements between two parties to buy or sell an asset at a predetermined price and date in the future. These contracts are often utilised to hedge against potential price fluctuations.

5. Credit Derivatives

   Credit derivatives are financial instruments that allow investors to transfer and manage credit risk. They enable market participants to isolate and transfer the credit risk associated with a debt obligation, protecting against possible debtor default or other credit events. The most common types of credit derivatives are credit default swaps (CDS), collateralised debt obligations (CDOs), total return swaps, and credit-linked notes.

   • Credit Default Swap (CDS)

     CDS is an agreement where the CDS seller compensates the buyer in case of a default or other credit event about an underlying reference entity. The buyer makes periodic payments to the seller, like an insurance premium, and receives protection against potential loss from a credit event. CDS contracts allow investors to hedge or speculate on changes in credit quality.

   Additionally Read: Demat Account Definition

   • Collateralised Debt Obligations (CDOs)

     CDOs are structured financial products that pool cash flow-generating assets and repackage this asset pool into discrete tranches. Each tranche has a different level of credit risk and returns to match the investment objectives of various investors. Various debt obligations can collateralise CDOs, including bonds, loans, mortgages, and other credit derivatives. They distribute risk across multiple asset classes, allowing credit risk to be split up and allocated more efficiently.

     Credit derivatives effectively allow financial institutions, investors, and other market participants to isolate, repackage, trade, transfer, and manage credit risk exposures. Their flexibility lets users fine-tune risk and return dynamics to meet specific portfolio requirements. When used judiciously, credit derivatives improve risk-sharing across the financial system.

Conclusion

Each type of derivative offers unique benefits and considerations, from futures and options to swaps and forwards. By delving deeper into the world of derivatives, investors can gain a better understanding of the financial markets and make more informed decisions.

Various types of derivatives, such as futures, options, and swaps, offer investors diverse strategies for managing risk and enhancing returns in the share market. To explore these opportunities, consider opening a demat account online, providing convenient access to trade and manage a wide range of derivative instruments efficiently.