Over- the Counter
An over-the-counter is a derivative that is not traded on an exchange, but is
purchased from, say, an investment bank.Exotics
Exotics are derivatives that are complex or are available in emerging economics
Plain- Vanilla derivatives
Plain vanilla derivatives, in contrast to exotics, are typically exchange-traded, relate to
developed economies and are comparatively uncomplicated.
Hedging with futures
Taking on one risk to off set another is hedging. The some of the tools required for
hedging are futures, forwards, and swaps. With options, they are known as derivative
instruments because one value of asset depends on the value of another asset.
Futures contracts
Futures were originally developed for agricultural commodities. For example, a
farmer expects to have 100 tons of wheat to sell next September. If he is worried that
the price may decline, he can hedge by selling 100 tons of September wheat futures at
a price that is set today. Farmer has to make delivery.
On the opposite a miller will buy wheat after the harvest. The miller agrees to take
delivery of wheat in the future at a price that is fixed today without option. The farmer
has hedged risk by selling wheat futures; this is termed a short hedge. The miller has
hedged risk by buying wheat futures; this is known as a long hedge.
The price of wheat for immediate delivery is known as the spot price. When the
farmer sells wheat futures, the price that he agrees to take for his wheat may be very
different from the spot price. But as the date for delivery approaches, a future contract
becomes more and more like a spot contract and the price of the future snuggles up to
the spot price.
The farmer may decide to wait until his futures contract matures and then deliver
wheat to the buyer. In practice such delivery is very rare, for it is more convenient for
the farmer to buy back the wheat futures just before maturity. If he is properly hedged,
any loss on his wheat crop will be exactly offset by the profit on his sale and
subsequent repurchase of wheat futures.