In the previous articles we discussed about what derivative contracts are and what are the uses of such contracts? However, one important point needs to be noticed. Today, if a new person wants to buy a derivative contract, they will be bewildered at the sheer amount of choice that they will have at their disposal. There are hundreds or even thousands of types of contracts that are available in the market. This may make it seem like a difficult and confusing task to deal with derivatives. However, that is not the case. True, that there are hundreds of variations in the market. However, these variations can all be traced back to one of the four categories. These four categories are what we call the 4 basic types of derivative contracts. In this article, we will list down and explain those 4 types:
Type 1: Forward Contracts
Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.
However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favorable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.
Type 2: Futures Contracts
A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present.
However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.
An important point that needs to be mentioned is that in case of a futures contract, they buyer and seller do not enter into an agreement with one another. Rather both of them enter into an agreement with the exchange.
Type 3: Option Contracts
The third type of derivative i.e. option is markedly different from the first two types. In the first two types both the parties were bound by the contract to discharge a certain duty (buy or sell) at a certain date. The options contract, on the other hand is asymmetrical. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.
There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price. Any individual therefore has 4 options when they buy an options contract. They can be on the long side or the short side of either the put or call option. Like futures, options are also traded on the exchange.
Type 4: Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well.
Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are usually not traded on the exchange. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a large amount of exchange rate risks.
So, these are the 4 basic types of derivatives. Modern derivative contracts include countless combinations of these 4 basic types and result in the creation of extremely complex contracts.
FAQs
The four major types of derivative contracts are options, forwards, futures and swaps.
What are the basic forms of derivatives? ›
In finance, there are four basic types of derivatives: forward contracts, futures, swaps, and options.
What are the four derivative financial instruments? ›
There are four basic types of derivatives – Forward Contracts, Futures Contracts, Options Contracts, and Swaps. A forward contract is a customized contract between two parties to purchase or sell an asset at some specified price (decided in the present) at a future date.
What are the 5 popular derivatives and how they work? ›
Five of the more popular derivatives are options, single stock futures, warrants, a contract for difference, and index return swaps. Options let investors hedge risk or speculate by taking on more risk. A stock warrant means the holder has the right to buy the stock at a certain price at an agreed-upon date.
What is 4 derivative? ›
Since 4 is constant with respect to x , the derivative of 4 with respect to x is 0 .
What is the four step rule in derivatives? ›
The following is a four-step process to compute f/(x) by definition. Input: a function f(x) Step 1 Write f(x + h) and f(x). Step 2 Compute f(x + h) - f(x). Combine like terms. If h is a common factor of the terms, factor the expression by removing the common factor h.
What is derivative and its types? ›
Derivatives are financial instruments whose value is derived from other underlying assets. There are mainly four types of derivative contracts such as futures, forwards, options & swaps. However, Swaps are complex instruments that are not traded in the Indian stock market.
What are the four types of hedging categories? ›
They include options, swaps, futures, and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indexes, or interest rates. It's possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.
What are the 3rd and 4th derivatives? ›
The third derivative is the derivative of the second derivative, the fourth derivative is the derivative of the third, and so on. The cycle repeats indefinitely with every multiple of four. A first derivative tells you how fast a function is changing — how fast it's going up or down — that's its slope.
What are the three main derivatives? ›
You're most likely to encounter four main types of derivatives: futures, forwards, options and swaps. As an everyday investor, you'll probably only ever deal directly with futures and options, though.
In four dimensions, there are 4 derivatives, the gradient, the curl, the hypercurl and the divergence.
What is the derivative of the product of 4 functions? ›
If our function was the product of four functions, the derivative would be the sum of four products. As you can see, when we take the derivative using product rule, we take the derivative of one function at a time, multiplying by the other two original functions.
What is the derivative of the constant 4? ›
The derivative is the measure of the rate of change of a function. −4 is a constant—that is, it never changes. Thus, its derivative is 0 , as is the derivative of any other constant. For more explanations as to why the derivative of a constant is always 0 , read the answers here.
What are the four second derivatives? ›
There are four second-order partial derivatives of a function f of two independent variables x and y: fxx=(fx)x,fxy=(fx)y,fyx=(fy)x, and fyy=(fy)y.
What are the four step processes? ›
The “Four-Step Problem Solving” plan helps elementary math students to employ sound reasoning and to develop mathematical language while they complete a four-step problem-solving process. This problem-solving plan consists of four steps: details, main idea, strategy, and how.
What are the types of derivatives in calculus? ›
Derivative rules
| Derivative sum rule | ( a f (x) + bg(x) ) ' = a f ' (x) + bg' (x) |
|---|
| Derivative product rule | ( f (x) ∙ g(x) ) ' = f ' (x) g(x) + f (x) g' (x) |
| Derivative quotient rule | |
| Derivative chain rule | f ( g(x) ) ' = f ' ( g(x) ) ∙ g' (x) |
Methods of Differentiation - Substitution, Chain Rule, Logarithm Rule.
Which functions are derivatives? ›
The derivative of a function f(x) is the function whose value at x is f′(x). The graph of a derivative of a function f(x) is related to the graph of f(x). Where f(x) has a tangent line with positive slope, f′(x)>0. Where f(x) has a tangent line with negative slope, f′(x)<0.
What are the 4 hedging techniques? ›
In short, the 4 main steps of a good hedging strategy are simple: take stock of your international financial situation, choose the strategy best adapted to your company and identify the corresponding financial products, and finally monitor your strategy in order to modify it if necessary.
What are derivatives in finance? ›
Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right.
There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
What is the 4th derivative of sin? ›
The fourth derivative of sin x also comes from an application of the constant multiple rule: d4 dx4 sin x = d dx (− cos x) = − d dx cos x = −(− sin x) = sin x.
What does the 4th derivative tell you? ›
The fourth derivative (jounce) tells us the rate of change in the “jerk” part of acceleration— those moments when the acceleration suddenly speeds up (or slows down) such as a lift or elevator ascending (or descending) quickly. Velocity starts at zero and increases from there.
What are the 4th 5th and 6th derivatives called? ›
The term snap will be used throughout this paper to denote the fourth derivative of displacement with respect to time. Another name for this fourth derivative is jounce. The fifth and sixth derivatives with respect to time are referred to as crackle and pop respectively.
What is the 4th derivative of position? ›
4th derivative is jounce
Jounce (also known as snap) is the fourth derivative of the position vector with respect to time, with the first, second, and third derivatives being velocity, acceleration, and jerk, respectively; in other words, jounce is the rate of change of the jerk with respect to time.
What is the 3rd derivative called? ›
Less well known is that the third derivative, i.e. the rate of increase of acceleration, is technically known as jerk j. Jerk is a vector, but may also be used loosely as a scalar quantity because there is not a separate term for the magnitude of jerk analogous to speed for magnitude of velocity.
What is theorem 6 of derivatives? ›
Theorem 6: Derivatives of Trigonometric Functions
When we differentiate cos x, we get -sin x. When we differentiate tan x, we get sec2 x. When we differentiate cot x, we get -cosec2 x. When we differentiate sec x, we get secx tanx.
What is the 7th derivative called? ›
Beta. The seventh derivative of position is called the "helicity", the eighth derivative is called the "spin angular velocity"
Where is derivative used in real life? ›
It is an important concept that comes in extremely useful in many applications: in everyday life, the derivative can tell you at which speed you are driving, or help you predict fluctuations on the stock market; in machine learning, derivatives are important for function optimization.
Who invented derivatives? ›
The modern development of calculus is usually credited to Isaac Newton (1643–1727) and Gottfried Wilhelm Leibniz (1646–1716), who provided independent and unified approaches to differentiation and derivatives.
derivative, in mathematics, the rate of change of a function with respect to a variable. Derivatives are fundamental to the solution of problems in calculus and differential equations.
What are the three basic derivatives? ›
The three basic derivatives (D) are: (1) for algebraic functions, D(xn) = nxn − 1, in which n is any real number; (2) for trigonometric functions, D(sin x) = cos x and D(cos x) = −sin x; and (3) for exponential functions, D(ex) = ex.
What are the three 3 ways in which derivatives can be used? ›
Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement.
What are the major types of derivative securities? ›
4 Common Types of Derivative Securities. There are four main types of derivative financial instruments—options, futures, forwards, and swaps.
What are the two basic types of derivative contracts? ›
Derivatives are financial instruments whose value is derived from other underlying assets. There are mainly four types of derivative contracts such as futures, forwards, options & swaps.
What are the 5 bases of differentiation? ›
Table of Contents
- Product Differentiation:
- Services Differentiation:
- Personnel Differentiation:
- Channel Differentiation:
- Image Differentiation:
The model approaches differentiation through five dimensions, which are 1) teaching arrangements, 2) learning environment, 3) teaching methods, 4) support materials and 5) assessment.
What is the derivative calculus rule? ›
General rule for differentiation: ddx[xn]=nxn−1, where n∈R and n≠0. The derivative of a constant is equal to zero. The derivative of a constant multiplied by a function is equal to the constant multiplied by the derivative of the function.
What is the third derivative called? ›
Less well known is that the third derivative, i.e. the rate of increase of acceleration, is technically known as jerk j. Jerk is a vector, but may also be used loosely as a scalar quantity because there is not a separate term for the magnitude of jerk analogous to speed for magnitude of velocity.
