Types of Derivatives

There are various types of Derivative Contracts. These contracts are either forward commitments or contingent claims. The most common ones are –

Forwards
Futures
Options
Swaps
Exotics

Example –

Jack and Jill enter into a contract on 1^st of January to buy and sell a bar of Gold for $100 at the end of the month. The transaction or trade will happen on 31^st of January, but they have agreed upon the price today. Both of them have an obligation under the contract to buy and sell the gold respectively. The price of gold will keep fluctuating in the open market, but for Jack and Jill, the price is pre-set.

Let’s consider 2 possible scenarios on 31^st of January –

The actual market price of Gold is $120 – Irrespective of this price, the transaction between Jack and Jill will happen at $100. Therefore, this contract benefits the buyer Jack, as he gets to buy the gold for $100 when the actual price is $120. For Jill, this contract has resulted in a loss of $20 as she has to compulsorily sell the gold for $100, when the actual price is $120. The contract has a positive value for Jack and a negative value for Jill.
The actual market price of Gold is $90 – In this situation, Jill can sell the gold to Jack for $100 instead of the current market price of $90 and gain a profit of $10. Jack loses $10 in this case as he has to compulsorily buy the gold for $100, when the actual price is only $90. The contract has a positive value for Jill and a negative value for Jack.

Actual Market price on 31^st January	Contract Price / Transaction Price	Profit / Loss of each Party	Value of the Contract
$120	$100	Jack = Profit of $20 Jill = Loss of $20	Jack = Positive Value Jill = Negative Value
$90	$100	Jill = Profit of $10 Jack = Loss of $10	Jill = Positive Value Jack = Negative Value

This is a Derivative contract, as it derives its value from the price of an underlying asset, which in this case is Gold.

Here is what we can conclude,

If the price of the Underlying Increases and goes above the agreed upon price ($120 > $100), the contract has a positive value for the Buyer.
If the price of the Underlying Decreases and goes below the agreed upon price ($90 < $100), the contract has a positive value for the Seller.