Classification of Derivatives

Derivatives are generally classified into contingent claims and forward commitments:

Contingent Claims: These are derivatives whose payoffs are dependent on the occurrence of a specific event. Examples include options and credit default swaps (CDS).

• • Call Option Contract (B): This is a contingent claim because its payoff depends on whether the underlying asset’s price exceeds the strike price at expiration.
  • Credit Default Swap (C): A CDS is also a contingent claim because its payoff depends on a credit event (e.g., default of a reference entity).

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Forward Commitments: These are derivatives where both parties are obligated to transact in the future at agreed-upon terms. Examples include futures, forwards, and swaps.

• • Futures Contract (A): A futures contract is a forward commitment because both parties are required to transact at the contract’s settlement date, regardless of market conditions. Since its payoff does not depend on a specific event occurring (like an option or CDS), it is least likely to be classified as a contingent claim.

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Classification of Derivatives

Derivatives can be classified based on different criteria, including how they derive their value, the type of contracts they represent, and their underlying assets. Below is a structured classification of derivatives:

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1. Based on the Nature of the Contract

A. Forward Commitments

These are contracts where both parties are obligated to transact at a future date under predetermined terms.

• Futures Contracts – Standardized contracts traded on exchanges, requiring the purchase or sale of an asset at a set price on a future date.
• Forward Contracts – Private, customizable agreements between two parties to buy or sell an asset at a future date.
• Swaps – Contracts where two parties exchange cash flows based on a predetermined formula (e.g., interest rate swaps, currency swaps, commodity swaps).

B. Contingent Claims

These derivatives depend on a specific event occurring for a payout to be triggered.

• Options (Call & Put) – Give the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a predetermined price.
• Credit Derivatives (e.g., Credit Default Swaps – CDS) – Pay out if a credit event (e.g., default) occurs.

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2. Based on the Trading Market

• Exchange-Traded Derivatives (ETDs) – Standardized contracts traded on organized exchanges (e.g., futures and listed options).
• Over-the-Counter (OTC) Derivatives – Customizable contracts traded privately between two parties (e.g., forwards, swaps, CDS).

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3. Based on the Underlying Asset

• Equity Derivatives – Based on stocks or stock indices (e.g., stock options, equity futures).
• Fixed-Income & Interest Rate Derivatives – Based on bonds or interest rates (e.g., interest rate swaps, bond futures).
• Currency Derivatives – Based on foreign exchange rates (e.g., forex forwards, currency options).
• Commodity Derivatives – Based on physical commodities like gold, oil, or agricultural products (e.g., commodity futures, swaps).
• Credit Derivatives – Based on credit risk or default events (e.g., credit default swaps).