Defining Derivatives

derived from the values of other underlying assets such as foreign exchange, bonds, equities or commodities. Since the values are related to the underlying assets they have certain useful characteristics and could be used for low cost hedging, speculating and arbitraging.

Derivative instruments can be classified according to three features: the type of contract, the underlying assets, and whether these instruments are traded on an exchange or in the over the counter (OTC) markets. The three basic types of derivative instruments are: forwards and futures, option contracts and swaps.

A forward/future contract is an agreement between two parties to exchange a fixed quantity of assets at a future date at a predetermined price. Futures contracts are exchange traded instruments whereas forward contracts are traditionally OTC products.

An option contract confers the right but not the obligation to buy or sell an asset at a predetermined price on or before a

fixed expiration rate. A call option on equities, for instance, would confer the right to buy a share at a particular price on a future

date, though not an obligation. A put option is the exact reverse--it confers the right to sell.

Swaps are agreements between two parties to exchange cash flows in the future according to a pre-arranged formula. The kind of swaps witnessed in the Indian markets are mostly in the interbank foreign exchange market. Here one bank agrees to exchange rupees for dollars and reverse the contract at a future date.

Swaps are also used in hedging interest rates, where one party agrees to pay the other party a sequence of fixed cash flows in exchange for variable cash flows ( exchanging fixed interest for floating interest). The fixed cash flows are equal to the interest payments on the fixed rate loan. Currency swaps also include the principal payments, where the exchange risk is also covered.

But derivatives could also be combination derivatives of: forward contracts and swaps swaps and options, or all these three derivatives. But these would only be OTC products.