Types of Derivatives
The derivatives market is one that continues to grow, offering investors an increasingly wide range of options. However, the main types of derivatives include futures, forwards, swaps, and options.
In the previous lesson, we discussed how derivatives are used in the commodities market, but derivatives can be used across various investment types. As mentioned, forwards and futures are essentially the same, as they both involve agreeing on a price today, that will be paid in the future. The main difference between a future and a forward is that a future is a standardised contract that is traded on an exchange, while forwards are customisable contracts that are bought over-the-counter (i.e. at a bank).
In this lesson, we will primarily focus on options and swaps.
Options are contracts that give an investor the option to buy or sell an asset in the future, at a pre-agreed price. If the price is no longer attractive in the future, they have the choice to not buy or sell an asset. There are two main types of options contracts.
The first is called a ‘call option’, while the second is called a ‘put option’. A call option gives an investor the option to buy an asset in the future, at a price that is agreed today. The holder of the call option has no obligation to go ahead with the purchase and can simply withdraw from the deal.
A put option, on the other hand, gives an investor the option to sell an asset in the future, at a price that was agreed today. If they are not happy with the sale price, as the value has increased since they made the deal, the put option holder can simply withdraw. In order to use put and call options, investors need to pay a premium. They are essentially like insurance policies that protect an investor from making a transaction that will not benefit them. For that reason, the cost of using an option may not always be justified.
Swap contracts are fairly easy to understand as they simply allow investors to swap their position in a particular investment. For example, if one investor owns Apple stock at a price of $95, while another owns Visa stock at a price of $150, they could agree to swap their investments if is a suitable deal for both investors.
Investors may use swaps to change the level of risk that their portfolio has or to acquire new stocks at favourable prices. Swaps are customisable contracts that are traded over-the-counter, between private parties.
Although swaps could be used with stocks, they are much more commonly used with interest rates or foreign exchange. Investors tend to enter into swap contracts to improve the interest rate that they pay on a loan or to increase the amount of money that they can gain when they convert one currency into another.
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