This chapter introduces the reader to some basic concepts that will be useful when reading subsequent chapters and in gaining a deeper understanding of derivatives. It describes the main types of derivatives, the economic functions of derivative markets and some related concepts.
Types of derivatives
Derivatives are described and classified in many ways. The primary method of describing derivatives is based on the type of contract.
Types of contracts
The main contract types are:
• Forward contracts
– Futures contracts (which are special types of forward contracts traded through an exchange and thus a sub-set of forwards)
• Swaps (in theory, these are similar to a string of forward contracts)
• Options contracts
• Complex derivatives (futures and options are the basic building blocks of complex derivatives)
– Forward rate agreements
– Range forwards
– Exotic options
Each of these types of contracts may have as its ‘underlying’ one of various kinds of assets. Thus, a futures contract can be on the share of an individual company (say, Tata Consultancy Services or TCS) or on a commodity (e.g., gold) or on a foreign currency (e.g., Japanese yen) and so on. Similarly, there can be options or swaps on various kinds of underlying assets or liabilities. Derivatives are thus often described on the basis of the type of contract and the nature of the underlying, e.g., ‘pepper futures’ means a futures contract with pepper as the underlying commodity, a ‘currency swap’ means a swap contract where the underlying is a foreign currency and so on.
Underlying assets are also grouped into classes, like commodities or financial instruments. Based on this classification, derivatives can be classified into the following.
• Financial derivatives in which the underlying is a financial instrument (individual share, a stock market index, bonds, a foreign currency, a cost of living index, a credit risk etc.).
• Commodity derivatives in which the underlying is a commodity which may include:
a. gold, silver and platinum often collectively known as ‘bullion markets’;
b. base metals like nickel, tin, lead, copper etc.;
c. ‘soft’ commodities like coffee, cocoa, cotton, etc.; and