A derivative is a financial instrument that derives its value/ price from the value of another asset, known as an underlying asset. The common underlying assets are stocks, bonds, commodities, currencies, interest rates etc.
The basic types of derivatives are forward, futures, options, and swap.
A forward contract is a contract between two parties to buy/ sell an asset on a specific date in the future at a pre-determined price.
It is mostly used for hedging purposes (insuring against price risk). For example: If you are a farmer producing onions and are concerned about the volatility in the prices of onions, you may enter into a forward contract. A contract to sell 100 kgs of onions to Arvind @ 40 per kg on 1/1/2018.
The contract will hedge the farmer against the possible decline in prices. But, for a contract to make sense, it must be beneficial to both the parties. Arvind must have entered the contract as he thinks that the prices of onion will be greater than Rs.40 on 1/1/2018 and he will not incur any losses.
Futures are similar to a forward contract. The difference is that futures are standardised agreements to buy or sell an asset in the future at an agreed upon price. Therefore, they can be traded on stock exchanges.
The value of the futures depends on the price of the underlying asset.
Futures can be used for hedging or speculation. Speculation means buying and selling an asset with the hope of making a profit.
There are two types of options. A call option gives the holder the right to purchase an asset at an agreed-upon price on or before a specified date. This agreed-upon price is known as the exercise price. It has to be noted that the holder has the option and can choose to not buy the asset.
The purchase price of the option is called the premium. It represents the compensation the purchaser of the call option must pay for the right (but not the obligation) to exercise the option.
It will make sense for the call option holder to exercise his option only if the market price of the asset is greater than the exercise price. Otherwise, he can buy the asset from the market at a lower price.
The call option should increase in value with the increase in the asset price. The call option is the right to buy an asset. Hence, it increases in value, if the price of the asset increases.
A put option gives the holder the right to sell an asset at a specified price. It will make sense for the put option holder to exercise his option only if the exercise price is greater than the market price of the asset. Otherwise, he can sell the asset in the market at a higher price.
The put option should decrease in value with the increase in the asset price. The put option is the right to sell an asset. Hence, it decreases in value, if the price of the asset increases.
A swap is a contract in which two parties exchange their future cash flows for a period of time. The most common type of swap is interest rate swap. In this, parties agree to exchange interest rate payments.
Let’s say Bank A has given out a loan that pays a flexible interest rate based on the market. The interest rate will fluctuate. Bank B has given out a loan that pays a fixed rate of interest. They can make a contract to exchange their interest inflows.
That is all for derivatives. A participatory note is also a derivative. Read: Participatory Notes Explained.