Derivative contracts are traded on an exchange and in over the counter markets. While they are standardized on exchanges, the contracts are customized to comply with the needs of the counterparties in OTC markets. Following is a quick glance at some of the key derivatives instruments
They are exchange traded financial contracts where the buyer is under obligation to buy the underlying asset and the seller to sell the asset at a predetermined time and price. Since these contracts are traded on an exchange, all the contract specifications such as the contract/lot size, price, quality of the asset and the maturity date are pre-defined by the exchange.
These contracts are more flexible when compared to futures since they allow the parties involved in the transaction to customize the contract/lot size, quality of the asset and the maturity date correspondingly.
Options give the buyer the right but not an obligation to buy or sell the underlying asset at a predetermined price and date and the seller the obligation to deliver or take delivery of the underlying asset if the buyer decides to exercise the option. Call options give the buyer the right but not the obligation to buy a given quantity of the underlying asset at a predetermined price on or before a future date (in the case of American options) and on a specific date (expiry date) in the case of European options. Put options give the buyer the right but not the obligation to sell a given quantity of the underlying asset at a predetermined price on or before an agreed future date.
Long Term Equity Anticipation Securities (LEAP’s):
They are long-term options contracts with expiration dates varying from nine months to three years. LEAPS give investors the opportunity to devise long-term strategies in an underlying asset without having to continuously rollover short-term contracts. They are generally used to hedge investments with less capital and without having to own or short sell the underlying security in the futures markets. However, since LEAP’s are longer-term options, the premiums are higher when compared to the shorter duration options.
Warrants are again similar to options except that they are issued by companies rather than a third party and are mostly traded over the counter. The underlying security in a warrant is “equities” and they give the buyer the right but not the obligation to buy or sell the underlying before expiration although investors cannot write a warrant like they do in regular options or LEAPS. Warrants are dilutive with investors receiving fresh equity rather than those already issued and trading in the secondary markets. Warrants generally do not pay dividends nor grant investors voting rights.
Are private agreements or contracts that allow the exchange of cash flow between two parties and are regarded as portfolios of forward contracts. The commonly used swaps are:
Interest Rate Swaps-
These involve swapping a stream of future interest payments for another based on a specified principal. In interest rate swaps, the exchange can involve one floating rate for another, also called “basis swap,” or an exchange of a floating interest rate for a fixed rate.
Here, the swap agreements between the counterparties can either involve swapping only the interest or both the principal and the interest where the cash flow of currencies in the two legs of the transaction are different from each other.
Example: Consider a currency swap involving the Chinese yuan and the UAE dirham where the transaction value is 10 million and the exchange rate is one CNY= 1.82626 AED. In the first leg of the transaction, one of the parties to the contract will receive 10 million AED while the other will get 10.82 CNY. On expiry, the two parties will swap again at the same exchange rate to close out the deal.
They are very similar to a futures contracts with the exception being that they are traded over the counter and all contracts are cash settled instead of the underlying security in the case of futures. CFD’s are highly leveraged instruments with margin requirements for some of them as low as 2-3 percent, multiplying risk and return manifold. Prices generally mirror the underlying securities trading on an exchange and investors get to benefit from corporate actions such as stock splits and cash dividends.
This is a type of financial derivatives where speculators place bets on the price movement of a security and wager a specific currency value for every point rise or fall in the security. The advantage of spread betting is the leverage offered to buy large quantities of the underlying security in addition to exemption from capital gains tax. On the flip side, the broker is generally the market maker and the size of the bid-ask spread is completely at the broker’s discretion which could result in large capital losses, not to mention counterparty risk.