1.1 Types of Derivative

This topic describes the Derivative types and Derivative Instruments.

Based on the market in which they can be traded, derivatives are broadly classified as

• Over-the-counter (OT) derivatives – These are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.
• Exchange-traded derivatives (ETD) – These are derivatives products that are traded via specialized derivatives exchanges or other exchanges.

The most common types of derivative instruments are as follows:

• Futures and Forwards – Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves
• A Forward rate agreement (FRA) is a specific type of a Forward. FRA is a contract between two parties in which one party agrees to lend and the other agrees to borrow a specific amount at a specified interest rate for a specified tenor. FRAs are settled through cash payments that represent the difference between the contracted rate and the spot value of the pre-determined market benchmark rate
• Options - An option is a contract between a buyer and a seller that gives the buyer the right but not the obligation to buy or to sell a specified amount of a particular asset (the underlying asset) at an agreed price on or before a particular day. In return for granting the option, the seller collects a payment called the ‘premium’ from the buyer. A ‘call’ option gives the buyer the right to buy an underlying asset; a ‘put’ option gives the buyer of the option the right to sell an underlying asset.
• Swaps - A swap is a transaction in which two counter parties agree to exchange one stream of cash flows against another stream over time. These streams are called the legs of the swap. Most swaps are traded over-the-counter. The most common type of swaps are:
• Interest Rate Swaps – also known as Vanilla Swaps. It represents contracts between two parties to exchange calculated interest obligations related to a certain amount of principal without exchanging the principal amount itself. For instance, One series of fixed rate interest rate flows is exchanged for another series of floating rate interest flows
• Cross Currency Swaps – A cross-currency swap is a contract between two counter parties for the exchange of loans in different currencies. Principal amounts are exchanged at the inception, with a re-exchange upon closure. Between the inception and the closing dates, a series of cash flows are made between the two parties reflecting the interest payments on the two swapped principal amounts.