Hedging

Hedging is a means to reduce or completely eliminate risk. Incase of derivatives, the risk about the price of an underlying asset can be transferred from one party to another. For example, a person wants to buy a TV which costs Rs. 35,000/- but does not have that much money at present. So he enters into an agreement with the TV dealer to pay this amount after 3 months irrespective of the price of that TV after 3 months. This is nothing but a type of derivative contract known as futures contract. Here, we can see that the risk in change of price of the TV [underlying asset] is hedged against through a derivative contract.

Speculation and Arbitrage

Derivatives can also be used to acquire risk, rather than to hedge/insure against risk. Some individuals as well as institutions enter into a derivative contract to speculate on the value of the underlying asset, betting that the judgment of the party about the future value of the underlying asset will be wrong. When the future market price is high, speculators will buy the asset in the future at a low price according to the derivative contract, and when the future market price is low, speculators will sell the asset in the future at a high price according to the derivative contract. Individuals and institutions may also look for arbitrage opportunities arising because of the differences present in the prices of assets in different markets. 

Types of derivatives

• Over-the-counter [OTC] derivatives - These are contracts that are traded between 2 parties without going through any other intermediary or exchange. Products like exotic options, swaps and forward rate agreements are mostly traded in this manner.

   

   

• Exchange Traded derivatives [ETD] - These are derivative products which are traded through derivative exchanges or other exchanges. The exchange acts as an intermediary for all related transactions and charges an initial margin from both parties to act as a guarantee.

   

   

• Futures & forwards - These are contracts to buy/sell an asset on/before a future date at a price which is specified today. Futures contract is a standardized contract that is written by a clearing house that operates an exchange where the contract can be bought and sold; where as a forward contract is a non-standardized contract that is written by the parties themselves

   

   

• Options - These are contracts that give the owner the right, but not an obligation, to buy (call option) or sell (put option) an asset. The price at which the sale takes place is known as the strike price. The strike price is specified at the time when the parties enter into the option. The contract also specifies the maturity date

   

   

• Swaps - These are contracts exchange cash (flows) on / before a specified future date based on the underlying value of bonds/interest rates, currencies/exchange rates, stocks, commodities, or other assets. 

Other examples of derivatives

Based on the type of underlying asset/underlying exchangeable, following are the types of derivatives:

• Interest rate derivatives

• Foreign exchange derivatives

• Credit derivatives

• Equity derivatives

• Commodity derivatives

• Property (mortgage) derivatives

• Economic derivatives

• Freight derivatives

• Inflation derivatives

• Weather derivatives

• Insurance derivatives 

thanks manish sir for providing such useful info.. sir , can u explain swap n option derivatives with example ? 

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

· Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

· Currency swaps: These entail swapping both principal and interest

between the parties, with the cash flows in one direction being in a

different currency than those in the opposite direction.

Options: Options are of two types - calls and puts.

Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

for more details about options refer this link

/forum/introduction-to-option-99189.asp

thank you so much sir for making me understand these concepts.