How a Derivative Contract Works and What are the types of Derivatives?

SYNOPSIS

After understanding what derivatives are and why the derivatives market exists, the next step is to learn about the different types of derivatives and how these contracts work. This blog explains the four major types of derivatives, how profits and losses are generated, the role of margins, and the key elements of every derivative contract.

Imagine knowing today how much you'll pay for gold, crude oil or even a stock next month - regardless of how prices change. Sounds impossible? That's exactly what derivatives make possible.

Let’s understand the types and the workings with a help of example. Imagine Rohan owns a jewellery shop in Indore. Every month, he has to purchases gold to manufacture jewelleries. Say, today, the price of gold is ₹1,00,000 per 10 grams, but he is worried that by the time he buys gold probably, next month, prices may rise significantly, pertaining to boost in the demand. Now, instead of waiting and taking the risk, he enters into a derivative contract that allows him to lock today's price for a future purchase.

This is one of the simplest examples of how derivatives are used in everyday business. They help individuals and companies manage uncertainty caused by changing prices.

The Four Major Types of Derivatives:

Rohan has four different choices, he can alter the contract, according to the need.

Forward Contract is a private agreement between Rohan and a gold supplier, where the price, quantity and delivery dates are set according to the needs, as these contracts are customised, they are traded over the counter.

Futures Contract works similarly, but here Rohan trades through a recognised stock exchange. The exchange decides the contract size, expiry date and settlement process. As the exchange is involved, these are more transparent and low lower risk as compared to forwards.

Suppose Rohan is not completely sure whether or not he will need the gold next month. Instead of locking himself into a compulsory contract, he can buy an Option Contract. By paying a small premium, he gets the right, but not the obligation to buy gold at today's price i.e predetermined price. If gold prices increase, he exercises the option and benefits. If prices fall, he simply lets the option expire and purchases gold at the lower market price. There are two types: Call Options (right to buy) and Put Options (right to sell).

Globally, companies often use Swaps. For example, one company have a loan with a floating interest rate while another has a fixed interest rate, now according to the financial needs, they can swap the interest rates payment obligations, allowing each to benefit from a more suitable borrowing structure.

How Does a Derivative Contract Work?

The derivative contracts are based on an underlying asset, in Rohan's case the underlying asset is gold. Further, derivatives can also be based on stock indices, stocks, bonds or interest rates.Every contract specifies:

• Underlying asset: The asset on which the contract is traded.

• Contract Size: Each contract represents a fixed quantity called the lot size.

• Expiry Date: Each derivative has a fixed validity period after the expiry, the contract automatically ends.

• Contract Price: The price agreed when entering the contract. • Settlement method: When a contract expires, settlement happens either physically, where actual asset is delivered or in cash where only the profit or loss is calculated and settled in cash.

How are Profits Generated?

Say, Rohan entered into a futures contract to buy gold at ₹1,00,000 and a month later, the gold price rises to ₹1,08,000, now as he has already locked the purchase price at ₹1,00,000, he would gain ₹8,000 per 10 grams. However, if the market price falls to ₹95,000, he would have suffered a loss as he agreed to buy at a higher price.

What are Margins?

Margins act as a security deposit when entering a future contract, instead of paying for a full contract, one can deposits only a small amount called margin. Say, total contract value is ₹10 lakh, one has to only deposit a certain percent as margin as decided by the clearing corporation, this allows traders to hold a large contract with less capital.

Conclusion

Derivatives are much more than financial trading instruments, they are crucial decisions and managing risks. Whether it is a jeweller protecting against rising metal prices, a farmer securing crop prices or an investor managing market volatility, derivatives help reduce uncertainty in rapidly changing market.

Palak Patel