We can also categorise derivative products based on the mode or the place of trading.

1. Exchange traded derivatives: Derivatives traded on the regulated exchanges are highly standardized, (example - exchange traded futures & options). Options & Futures contracts are standardized. In other words, the parties to the contracts do not decide the terms of futures/option contracts; but they merely accept terms of contracts standardized by the Exchange. Exchange traded derivatives offer the maximum protection to the investor thanks to various regulatory measures enforced by SEBI to provide for fairness and transparency in trading.

2. Over the counter derivatives: Encompass tailored financial derivatives, such as swaps, swaptions, caps and collars, that are traded in the offices of the world's leading financial institutions. These contracts are customized. In other words, the terms of OTC contracts are individually agreed between two counter-parties.

Over-the-counter (OTC) derivatives are private contracts negotiated between parties. The chief advantage of OTC derivatives markets is limitless flexibility in contract design. The underlying asset can be anything, the size of the contract can be any amount, and the delivery can be made at any time and at any location. The only requirement of an OTC contract is a willing buyer and seller.

Among the disadvantages of OTC markets, however, is that willing buyers and sellers must spend time identifying each other. Another disadvantage of OTC derivatives is credit risk, that is, the risk that a counterparty will renege on his contractual obligation.

Derivatives can also categorised in terms of the nature of the underlying asset. Derivative contracts are written on four types of assets -

• stocks,

• bonds (i.e. interest warrants),

• foreign currencies and

• commodities.

Another distinction is between-

• vanilla (simple and more common products) and

• exotic derivatives (more complicated and specialized).

These types of the derivative instruments are least seen as compared with the other instruments as options and futures, which are, used worldwide as because they are most complicated and complex contracts. These contracts are not exchange traded they are simply made on OTC derivative industry. An essential feature of derivatives exchanges is the contract standardization.

Swap can be defined as "A financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, over time". Generally, two types of swaps are generally seen i.e. interest rate swaps and currency swaps. Even two more swap are being introduced as commodity swaps and the tax rate swaps which are seen to be an extension of the conventional swaps. A swap results in reducing the borrowing cost of both parties.

Here, interest payments streams of differing characters are periodically exchanged. There are three main types:

1. Coupons swaps: fixed for floating rates

2. Basic swaps: the exchange of one bench-mark for another under floating rates

3. Currency swaps: cash flows in one currency for cash flows in another

Many banks and authorized dealers quote the interest rate swap (fixed to LIBOR) with the help of Reuters service. The quotes generally are for the fixed rate receipt and payment against LIBOR payment and receipt. For US Dollar quotes are generally in terms of basis points over treasury yields (also known as swap spreads), but for other currencies actual fixed rate is mentioned.

It involve cash flows(on principal and repayments alone) in two currencies. The exchange rate used is the ruling spot rate between the two currencies. A currency swap can also be considered as a series of forward contracts. Even a currency swap can be combined with an interest rate swap, in that case, the dollar outflows would carry LIBOR-based interest rate. As weaker counter parties would not be able to get swap quotes for a longer maturity.

International Banks offers a commodity price swap-exchanging floating price for the fixed price. Such swap reduces the volatility of cash flows. The maximum trading in the derivative products as for options and futures is in Chicago. Spot-futures arbitrage increases the flow of market order to the cash market. This increase the cash revenue of the daily traders who do their work on limited orders and induces an increase supply of limit orders. This will improve the liquidity of the cash market.

A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments for a 'notional principal' amount on settlement date , for a specified period from start date to maturity date . Accordingly , on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed bench-mark/ reference rate prevailing on the settlement date.

"A great deal can be learned about valuing derivatives under minimal assumptions. The sole necessary assumption is the law of one price (LOP). Stated simply, the LOP says that two perfect substitutes must have the same price. If they do not, a costless arbitrage product can be earned by simultaneously buying the cheaper asset and selling the more expensive one. Because the same asset is bought and sold simultaneously, the position is risk-free. This is the key attribute of an arbitrage strategy . The fact that the strategy involves no initial cash outlay makes it costless. The absence of costless arbitrage opportunities is fundamental in derivatives contract valuation. A second assumption is that markets are frictionless. Frictionless markets have a number of attributes including:

1. No trading costs.

2. No differential tax rates.

3. Unlimited borrowing and lending at the risk-free rate of interest.

4. Freedom to sell (short), with full use of any proceeds.

5. Can trade at any time and in any quantity.

The frictionless market assumption is made largely for convenience. By ignoring market frictions, pricing relations can more easily be identified. In most cases, the impact of considerations such as trading costs, taxes, and divergent borrowing and lending rates can be and have been introduced into the valuation framework straightforwardly. Indeed, the very presence of these market restrictions has caused many derivatives markets to thrive."
[Source: From Article titled Derivatives published by Robert E. Whaley, Faculty, Fuqua School of Business, Duke University, USA]

There are different pricing models for various derivatives products. But all these view the spot price of the underlying in the cash market as the basic factor to start calculations. The price of the derivatives product is assessed taking into account the variable factors influencing the price/value of the underlying in the intervening period in the market. Thus All pricing of derivatives is done by arbitrage, and by arbitrage alone. Here, there is a relationship between the price of the spot and the price in the futures. If this relationship is violated, then an arbitrage opportunity is available, and when people exploit this opportunity, the price reverts back to its economic value. Therefore, arbitrage is the basic requirement for pricing. The role of liquidity i.e. the low transaction costs is in making arbitrage cheap and convenient.

Two methods generally used for predicting futures prices are fundamental analysis and technical analysis. The fundamental analysis is concerned with basic supply and demand information, such as, market patterns, carryover supplies, relevant policies of the Government and financial/economic reports/forecasts. Technical analysis includes analysis of movement of prices in the past. Many participants use fundamental analysis to determine the direction of the market, and technical analysis to time their entry and exist. More information on pricing methods in the next page