Types of Financial Derivatives

Posted on Monday, January 4, 2010
This was posted in Accounting and Finance

Derivatives can be classified in different ways. Some of these are:
1. Commodity derivatives and financial derivatives: Derivative contracts can be entered into for different type commodities such as sugar, jute, pepper, gur, castor seeds etc. In India, futures contracts in 6 commodities are available at different commodities exchanges. For example, futures in pepper are available at Kochi, while futures in potatoes are available at Hapur. On the other hand, the derivatives in currencies, gilt – edged securities, shares, shares indices, etc. are known as financial derivatives. These are transacted at different exchanges all over the world. In India, dealing in Stock Index Futures has started only recently.

2. Basic derivatives and complex derivatives: The basic derivatives are the derivatives on underlying assets. Futures and Options are two basic derivatives. However, there are certain other derivatives such as swaps which may be classified as complex derivatives.
In practice, different types of financial derivatives have been used as a tool of risk management.

Futures:
A futures contract, or simply called futures, is a contract to buy or sell a stated quantity of a commodity or a financial claim at a specified price at a future specified date. The parties to the futures have to buy or sell the asset regardless of what happens to its value during the intervening period or what shall be the price on the date for which the contract is finalized. Transaction agreements in assets can be broadly classified as:
1. Spot or ready delivery contract where the asset is to be physically delivered immediately or within few days and payment made in cash.
2. Futures Delivery contract, where the physical delivery of the asset is slated for a future date and the payment to be made as agreed. The future delivery contracts may be further classified as:
- Non – transferable future delivery contracts, where the contract must be performed by the parties as per the terms and conditions mentioned therein.
- Transferable future delivery contracts, where the parties to the contract can transfer the rights and obligations under the contract to a third party.

Determination of Future Prices:
The price of the futures refers to the rate at which the futures contract will be entered into. The basic determinants of futures price are spot rate and other carrying costs. In order to find out the futures prices, the costs of carrying are added/deducted to the spot rate. The costs of carrying depend upon the time involved and rate of interest and other factors. On the settlement date, the futures price would be the spot rate itself. However, before the settlement day, the futures price may be more or less than the prevailing spot rate. In case, the demand for future is high, the buyer of futures will be required to pay a price higher than the spot rate and the additional charge paid is known as the contango charge. However, if the sellers are more, the futures price may be lower than the spot rate and the difference is known as backwardation. For example, with reference to the Stock Index Futures, the pricing would be such that the investors are indifferent between owning the share and owning a futures contract. The price of stock index futures should equate the price of buying and carrying such shares from the share settlement date to the contract maturity date. The financing cost of buying the shares would generally be more than the dividend yield. This means that there is a cost of carrying the shares purchased. So, the price of a futures contract will be higher than the price of the shares. The carrying cost of Stock Index Futures may be written as:
Index value X (Financing Cost – Dividend yield) X t
Where t is the time period from share settlement date to the maturity date of the futures contract.
For example, if the Index level is 4500, rate of interest (financing cost is 12%), the dividend yield is 4% and the futures contract is for a period of 4 months, the carrying cost in terms of basic points is:
Carrying cost = 4500 (12% – 4%) X 4/12 = 120 basic points.
The value of the futures contract is 4500 + 120 = 4620 points for a period of 4 months.

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