What Are The Different Types Of Derivative Contracts

The four major types of derivative contracts are options, forwards, futures and swaps.

• Options: Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a certain period of time. The buyer is not under any obligation to exercise the option. The option seller is known as the option writer. The specified price is known as the strike price. You can exercise American options at any time before the expiry of the option period. European options, however, can be exercised only on the date of the expiration date.

• Futures: Futures are standardised contracts that allow the holder to buy/sell the asset at an agreed price at the specified date. The parties to the futures contract are under an obligation to perform the contract. These contracts are traded on the stock exchange. The value of future contracts is marked to market every day. It means that the contract value is adjusted according to market movements till the expiration date.

• Forwards:Forwards are like futures contracts wherein the holder is under an obligation to perform the contract. But forwards are unstandardised and not traded on stock exchanges. These are available over-the-counter and are not marked-to-market. These can be customised to suit the requirements of the parties to the contract.

• Swaps: Swaps are derivative contracts wherein two parties exchange their financial obligations. The cash flows are based on a notional principal amount agreed between both parties without exchange of principal. The amount of cash flows is based on a rate of interest. One cash flow is generally fixed and the other changes on the basis of a benchmark interest rate. Interest rate swaps are the most commonly used category. Swaps are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.