What are the Different Types of Derivatives and the Risks Associated?

What are the different types of derivatives and the risks associated?

There is so little written about derivatives, given that these are high-risk instruments, and you need ample knowledge before you embark on your journey to investing in them. If you do have the risk appetite to indulge in derivatives either for speculative trading or purely for hedging, then it is time you equip yourself with some derivatives cognition. Read on to learn more about derivatives.

The growing interest in derivatives

Derivatives are becoming increasingly popular, especially among millennials who are game for the additional risk, which has the potential to give them supernormal returns. The daily average turnover for equity futures has surged by 4.2 times over the past ten years, from 33,305 crores in 2011 to over 1.41 lakh crore in 2021. From 11,187 crore in 2011 to 69,644 crore in 2021, the cash market's daily average turnover climbed by 6.2 times. According to figures published by the Futures Industry Association (FIA), a trade organization for derivatives, the NSE is the largest derivative market in the world based on the number of contracts executed again for the third straight year in 2021. Need we say more about the growing popularity of derivatives? Let’s get on with the basics.

What are derivatives?

An investment whose price is based on or derived from one or more underlying assets is referred to as a derivative. A contract between two or more parties based on the asset or group of assets is the derivative. Equities, commodities, bonds, and currencies are some of the most widely used underlying assets. Any change in the underlying asset's value affects its value. The two major uses of derivative contracts are speculation and hedging.

What are the risks associated with derivatives?

Derivatives are traded on OTC (over the counter) or exchanges just like stocks. Derivatives traded on exchanges are standardized. However, OTC derivatives make up the majority of the market and are not regulated. The risk to the counterparty is typically higher with OTC derivatives than with standardized contracts. Apart from this, there are many risks applicable to derivatives. Below is a list of risks that you need to be aware of before investing in derivatives.

1. Counterparty risk: We have already written briefly about this, although it is more common on the OTC platform. It can also arise in the standardized contract. This risk is known by alternate names such as credit risk, legal risk, settlement risk, etc.
2. Market risk: Instead of one or more securities falling out of favor, the danger is that the market as a whole might start declining. Economic recessions, changes in interest rates, and other factors can all increase market risk. It is crucial to do extensive study and assess the likelihood that an investment will be lucrative in the future before you begin trading derivatives.
3. Extreme volatility: Markets are prone to extreme volatility, and derivatives that derive value based on the underlying asset face even higher volatility. In derivatives, the possibility of losing the entire value in unfavorable market conditions is quite high.
4. Duration risk: Derivatives carry an expiry date ranging between 30 days to 3 months. Upon expiration, the derivative contract becomes of zero value. If the investment doesn't succeed within that time frame, you will end up with losses.

What are the types of derivatives?

There are 4 types of derivatives popular in the Indian scene: Futures, Options, Forwards, and Swaps.

1. Futures:

Futures are regulated and standardized contracts that provide the holder with the right to acquire or dispose of the asset at the predetermined price and date. The contracting parties to the futures contract are obligated to carry out their obligations as per the agreement. Future contracts are traded on the stock exchange and hence, are well aligned to the clearing and settlement processes. Futures contracts' values are marked to market daily. It denotes that up to the contract's expiration date, the value of the contract is modified following market trends. For example, an individual can enter a future contract to buy Infosys stock for 3 months hence at Rs. 1600. He will be required to pay a nominal premium to lock in this price well into the future, which is called the premium. Rs. 1600 in the example refers to the strike price, and 3 months is the contract’s tenure.

2. Forwards:

Similar to futures contracts, forward contracts also require holders to fulfill their obligations. However, forwards are still not traded on stock exchanges and are not regulated and hence, not standardized. These may be purchased without a prescription and are not labeled to sell. These can be modified to meet the needs of the contracting parties. An example would be a farmer locking in the price of rice at Rs. 600 per 10 kgs with a wholesale dealer 6 months before harvest. Typically, these are executed OTC. There is no standardized format for execution. It may so happen that at the designated time, either of the parties does not agree to the terms and conditions that they agreed upon previously, resulting in counterparty risk.

3. Options:

Options grant the purchaser the right to purchase or sell the underlying asset at the designated price for a predetermined time. The option holder or the buyer is not obligated to exercise the option if the market is unfavorable. The option writer is often referred to as the options seller. The pre-determined price of the option at which the underlying asset can be bought or sold is called the strike price. There are 2 types of options - the put option, which provides the buyer of the option the right to sell the underlying asset at a predetermined price during a certain period; the call option provides the buyer of the option the right to buy the underlying asset at a predetermined price during a certain period.  For example call option for Infosys @ Rs. 1600 with an expiry of 3 months hence can be bought at Rs. 50. Here, the buyer of the option will have the right to buy Infosys stock at Rs. 1600 (strike price) at the time of expiry (3 months hence), the seller of the option receives Rs. 50 (option premium) and, in return, is obligated to sell the shares at the designated date at the predetermined price if the buyer of the option chooses to exercise the option. Based on the time of exercise, the options can be categorized as  American options, which may be exercised at any time before contract expiry, and European options can be exercised on the day of their expiration date. In India, all exchange traded options (index and stock options) are European options.

4. Swaps:

Swaps allow the financial liabilities of two parties to be exchanged. The cash flows are predicated on a nominal principal sum that both parties have agreed upon without the actual principal being exchanged. Based on an interest rate, the cash flow amount is determined. One cash flow is typically constant, whilst the other fluctuates based on a benchmark interest rate. The most popular type of exchange is the interest rate. Swaps are over-the-counter agreements between corporations or financial institutions that are not traded on stock exchanges.

The derivative world is a reasonably vast area where you may have to spend some time and learn the ropes before you put your money. You can always reach out to experts who will guide you in this journey, irrespective of your route. Remember always to make informed decisions!