Derivatives

Anything that can be derived from the underlying asset is called a derivative.

For example, the curd is derived from milk. So here curd is the derivative and milk is the underlying product. Similarly, butter can be derived from curd, here butter is derivative and curd is the underlying product.

Derivatives can be split into 2 types.

1) OTC - Over the counter

2) ETD - Exchange-traded derivative

OTC - It can be traded directly between two parties without the supervision of an exchange.

ETD - It will be traded in the public stock exchange under supervision.

Types of ETD

1) Futures

2)Options

Types of OTC

1)Forward

2) Swaps

Forward: Here two parties will agree to pay/sell an asset on a specific date and price. For example, a farmer who seeds onion cultivation today, might not be aware of the demand while harvesting. So he will agree with the buyer to sell him all onion at a specific price, let’s say ?50per kg on a specific date 22/12/2023. Irrespective of market demand next year the farmer will sell all his stocks at the rate of ?50, even if the current market at that time is higher or lower. This contract avoids major volatility between buyer and seller.

Types of Swaps

1)CDS- credit default swaps

2)IRS - Interest rate swaps

3)ZCS - Zero coupon swaps

4)TRS-Total return swaps

5)CS- commodity & currency swaps

CDS- For example if a general partner invests 1 million amount in junk bonds for high returns (20%)after knowing it’s high risk. Then he will ensure this CDS transaction to protect against any default on payments. This insurance has called buyer protection and in case of any default, the insurance company needs to pay the entire amount this is called seller protection.

IRS

Let’s say two individual people A & B want to invest 1 million each.

A invests in fixed deposit with a 5% yearly return.

B invests in Chit funds with floating interest currently they giving 6%.

Now A wishes to swap IR with B and is willing to take a risk he thinks B's investments will give high returns whereas B needs stable income or thinks his chit-fund interest rate will go down, so they both decided to swap. At the end of the year if chit fund investment goes less than 5% B will be benefited or if it goes above 6% A will be benefited. In IRS only interest rates are swaps not their principal amount

TRS

In a total return swap, one party makes payments according to a set rate, while another party makes payments based on the rate of an underlying or reference asset. A has 1Million dollars and he doesn’t want to invest directly in S&P. So he invests through a bank and the bank will be investing 1M in S&P for the exchange of LIBOR +1% tax. At end of the year if S&P makes more than the LIBOR rate then the bank needs to pay the rest to the investor.

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