Broadly derivatives can be classified into below categories:
1. On the Basis of Underlying Assets
“Underlying asset” is a term used in derivatives trading, such as with options. A derivative is a financial instrument whose price is based, or derived, from a different asset. The underlying asset is the financial instrument – for example, stock, futures, commodity, currency, or index – on which a derivative’s price is based.
1. Equity Derivative
An equity derivative is a derivative instrument with underlying assets based on equity securities. An equity derivative’s value will fluctuate with changes in its underlying asset’s equity, usually measured by the share price. Options are the most common equity derivatives as they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds, and stock index futures.
2. Interest Rate Derivatives
An Interest Rate Future (IRF) is a financial derivative that uses an interest-bearing instrument as the underlying asset. It is a standardized interest rate derivative contract traded on a recognised stock exchange to buy or sell a national security, or any other interest-bearing instrument, or an index of such instruments or interest rates at a specified future date. The price of this contract is determined at the time of formation. Interest Rate Futures are relatively new entries in the domain of financial instruments and have become one of the most successful globally.
These futures are traded in various maturities and currencies and across different markets, including mortgages, federal issuance, and short-term commercial paper. Examples of Interest Rate Futures include Treasury bill futures, Treasure bond futures, and Euro-Dollar futures.
3. Foreign Exchange Derivative
Any financial instrument which guarantees a future foreign exchange rate is often utilised by currency or forex traders and large multinational corporations. The latter usually employ these products when they anticipate receiving substantial amounts of money in the future and wish to hedge their exposure to currency exchange risk. Financial instruments falling under this category include currency options contracts, currency swaps, forward contracts, and futures contracts.
4. Commodity Derivatives
In the case of commodity derivatives, the underlying assets can be commodities such as wheat, gold, silver, and so forth. On the other hand, financial derivatives have underlying assets that comprise stocks, currencies, bonds, and other securities bearing interest rates, etc. Hence, futures, options, or swaps on assets like gold, sugar, jute, pepper, and others are classified as commodity derivatives.
5. Credit Derivative
Credit derivatives are structured based on credit instruments or loans, where the payoff is determined by a credit event. These contracts are tied to a reference asset from a third party. Examples of credit derivatives include credit default swaps, credit default options, and collateralized bond obligations.
2. On the Basis of Financial Derivative Trading in India
A forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made.
This text refers to a legal contract that stipulates an agreement for the purchase or sale of a specific quantity of foreign exchange set to take place on a future date at a specific time on a designated stock exchange. This specific future date is referred to as the settlement date or delivery date. The current price, in this context, is also known as the future price.
An option buyer acquires the right to buy or sell a specified amount of one currency for another at a specific rate. The transaction date is also predetermined. The buyer of the option is not obligated to execute the transaction; instead, the decision is left to their discretion. Options are available in two variants: a call option and a put option.
In this type of transaction, financial intermediaries are tasked with purchasing and selling a specific foreign currency for varying maturity dates. The swapping process leads to the simultaneous buying and selling of the identical foreign currency but for different maturity dates. The value of the contracts is maintained consistently. This method is employed to manage risk. The process may also be utilised for arbitrage purposes, a practice that involves exploiting price differences occurring in two or more distinct markets.
3. On the Basis of Market in which they Trade
1. Exchange-Traded Derivative Market
As the term implies, derivatives trading on an exchange are referred to as exchange-traded derivatives. In the Exchange Traded Derivatives Market, the exchange serves as the chief party. The trading of derivatives essentially involves the transfer of risk between two parties. The party purchasing a futures contract is deemed to go “long,” and the one selling the futures contract is said to go “short.” Exchange-traded derivatives are standardized contracts with pre-determined exercise prices and standard expiry months, specifically, March, June, September, and December. The main centres for this trade are the Philadelphia Stock Exchange and the Chicago Mercantile Exchange. Access to the market is provided through brokers who charge commissions for each contract traded. The market operates on the exchange floor, where brokers congregate to match their clients’ orders with market makers. Each currency market in these exchanges has defined opening and closing times.
2. OTC Derivatives Markets
Brokerages facilitate transactions by bringing parties together but do not participate in the transaction themselves. A fee is levied on both counterparties by the broker for such deals, and trades concluded directly are subject to commission fees. Typically, stocks are traded over-the-counter because the company is small and unable to meet exchange listing requirements. These securities, also known as “unlisted stock,” are traded by broker-dealers who negotiate directly with one another over computer networks and by phone.
The main participants of the OTC market are Investment Banks, Commercial Banks, Government-Sponsored Enterprises, and Hedge Funds. Investment banks market derivatives through traders to clients like hedge funds.
Compared to exchange-traded derivatives, the OTC derivatives markets have the following features:
- The management of counter-party (credit) risk is decentralised and located within individual institutions;
- There are no formal centralised limits on individual positions, leverage, or margining;
- There are no formal rules for risk and burden-sharing;
- There are no formal rules or mechanisms to ensure market stability and integrity and to safeguard the collective interests of market participants;
- OTC contracts are generally not regulated by a regulatory authority or the exchange’s self-regulatory organisation. However, they are indirectly affected by national legal systems, banking supervision, and market surveillance.
4. On the Basis of Complexity:
1. Hybrid/Exotic/Sophisticated Derivatives
Exotic derivatives are a unique category of financial assets. These are derivatives or assets whose value is derived from another underlying asset that does not have a standard payoff, unlike a regular call option. Exotic derivatives refer to any derivative security not categorised as a European or American vanilla call or put on a single underlying security. These options are more complex than those trading on an exchange and generally trade over-the-counter. For instance, one variant of exotic option is known as a chooser option. This instrument enables an investor to decide whether the option is a put or call at a specific point during the option’s life. Given the fact that this type of option can potentially alter over the holding period, it is clear that such an option would not be traded on a standard exchange. Hence, it is classified as an exotic option.
2. Weather Derivatives
Weather derivatives are financial products that enable an organisation to offset the financial risk due to a weather variable. These products allow companies to manage the effects of weather on the demand for their products. This hedging method reduces the volatility of future revenue, leading to a more predictable cash flow. A degree-day represents the deviation of a day’s average temperature from the reference temperature. It has been found to be a useful measure that energy suppliers can use to hedge their supply in adverse temperature conditions. The most common forms of weather derivatives include call options, put options, caps, floors, collars, and swaps. Some exotic varieties, like one-touch, digitals, barrier, and basket options, are also structured to meet specific needs.