A derivative is a financial instrument which derives its value from the value of the underlying asset / variable. Its value changes with change in the value of the underlying asset/variable. The underlying asset/variable can be securities, commodities, bullion, index of prices, currency, live stock or anything else even weather. Derivatives are generally used to hedge risk but can also be used for speculative purposes.
The different types of derivatives include forwards, futures, options, swaps etc. It is said that derivatives in the form of Futures Contracts on cotton were traded in India as far back as 1875.
Forward contract is a contract to trade in a particular asset (which may be a security, currency, commodity, etc.) at a particular price on a pre-specified date. Currency forward contracts are very popular OTC contracts in India.
Forward Rate Agreement (FRA) is an agreement to lend / borrow money for a specified period on a notional Principal on a particular date in the future at a rate that is determined today. It is an agreement where both parties agree to deal at a particular interest rate for a specific period decided beforehand for a predetermined amount. It is like a forward contract where the underlying is a loan or deposits both notional. FRAs are OTC contracts.
Futures are standardized forward contracts that are traded on an exchange and where the counter-party (the party with which the contract has been signed) is the exchange itself. Equity Futures are actively traded on the country’s stock exchanges and currency futures have recently been introduced in India.
Options are contracts where one party(buyer) has the right but not the obligation to trade or engage in a transaction in a particular asset / underlying / variable at a particular price (called strike price) on a pre-determined date/dates or in a particular time interval. Options are available as OTC products and as exchange-traded products. Options have many variations. Equity options are actively traded on the stock exchanges in India.
Interest rate swaps are normally agreements where one side pays the counterparty a particular interest rate (floating) and the other side pays an interest rate (fixed or floating based on some other benchmark). Arising from these are Overnight index swaps that are actively traded in Indian markets. These are swaps where the floating rate is an overnight rate (such as NSE MIBOR) and the fixed rate is paid in return of the compounded floating rate over a certain period. SBI DFHI also deals in Overnight interest rate swaps (OIS).