Derivatives are the types of contract wherein two parties enter in an agreement to buy or sell an asset in the future. An asset which is dealt in the contract is called ” underlying asset ”. The value of a derivative contract is derived from the performance of an underlying asset. In other words, change in the market value of an underlying asset also changes the value of a derivative contract. These contracts also have an expiration period after which they cease to exist.
Forward contract is an agreement between two parties to buy or sell an underlying asset in the future. In this type of agreement, terms and conditions ( such as type of underlying asset, strike price, delivery date etc. ) are mutually decided by the parties involved in it but actual delivery and consideration for the asset take place in the future on a specified date.
For instance – Ram ( buyer ) and Sham ( seller ) make a forward agreement on July 10, 2016 for 10 quintals of wheat at the price of 1500 / Quintal which will be expired after one month i.e. August 10, 2016. In this example, underlying asset is wheat, strike price is 1500 and expiry period is 1 month. It is a forward contract because terms and conditions of the agreement are decided by the parties themselves according to their own desire and convenience.
Futures contract is a bi – lateral agreement wherein two parties enter into an agreement to buy or sell and underlying asset in the future. The most prominent feature of futures contract is its standardization i.e. terms and conditions ( such as expiry date, strike price, underlying assets etc. ) of futures contract are pre-determined by the stock exchanges and are common for each and every party involved in it. In other words, customization of futures contract is not possible and terms and conditions of futures contracts are publically available.
Option is a type of derivatives contract wherein investors with a long position (i.e. buyer ) of option contract has a right to trade in their assets with the short investor ( i.e. seller ). The most significant feature of option contract is its different application over the buyer and seller of the agreement.
In other words, buyer of an option contract has a right but not an obligation to perform his duty ( i.e. he can withdraw his earlier commitment at the time of expiration of the contract ) whereas seller of an option has an obligation to perform his duty ( i.e. he cannot withdraw his earlier commitment ). Buyer of the option has to deposit some money ( called premium ) with the seller which empowers him to enjoy the right but not an obligation to exercise his / her option on the seller / writer. Option contracts are divided into two parts –
- Call Option – Buyer of a call option enjoys the right but not the obligation to buy and seller of a call option has the obligation to sell an underlying asset.
- Put Option – Buyer of a put option enjoys the right but not the obligation to sell and seller of a put option has the obligation to buy an underlying asset.