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27 September 2020

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Introduction to Derivatives


The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity.

Types of Derivative Contracts:

Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.

Forward Contracts:

These are promises to deliver an asset at a pre- determined date in future at a predetermined price. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties.

Futures Contracts:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. These are basically exchange traded, standardized contracts.

Difference between Futures and Forwards.
Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customized contract terms
More liquid Less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period

Options Contracts:

Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future.

Options are of two types - calls and puts.


give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.


give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.


Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.

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