Derivatives Explained: Forwards, Futures, Options & OTC vs Exchange

Published on 24 October 2025 by
Derivatives

The financial market offers several instruments for investors to manage risk, speculate, or hedge against price movements. Among them, derivatives play a key role in modern finance. A derivative is a financial contract whose value is derived from the price of an underlying asset such as stocks, commodities, currencies, or interest rates.

Derivatives help investors protect themselves from fluctuations in prices. They are widely used by traders, financial institutions, and corporations to manage financial exposure. The most common types of derivatives are forwards, futures, and options, which can be traded either through exchange-traded markets or over-the-counter (OTC) markets.

What are Derivatives?

A derivative is a financial instrument that derives its value from an underlying asset or benchmark. The underlying asset could be a commodity like gold or oil, a currency like the dollar, or a financial instrument like a stock or bond. Derivatives are mainly used for three purposes:

  • Hedging – To protect against price volatility.
  • Speculation – To profit from expected future price movements.
  • Arbitrage – To take advantage of price differences across markets.

The most commonly traded derivatives include forwards, futures, and options. Each has unique features, pricing mechanisms, and risk profiles.

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Types of Derivatives

Derivatives are financial contracts that vary in structure and purpose. The main types are forwards, futures, options, and swaps. Each type serves different needs while forwards and swaps are customized OTC contracts, futures and options are standardized and traded on exchanges for better transparency and risk control.

1. Forwards

A forward contract is a customized agreement between two parties to buy or sell an asset at a predetermined price on a future date. These contracts are not standardized and are usually traded in the OTC (Over-the-Counter) market.

FeatureDescription
NaturePrivate and customized contract between two parties
Trading PlatformOver-the-counter (OTC)
StandardizationNon-standardized (customized terms)
RiskHigher counterparty risk
SettlementOn the contract’s maturity date

Forwards are commonly used by businesses to hedge against future price changes in commodities or currencies.

2. Futures

A futures contract is similar to a forward contract but is standardized and traded on a regulated exchange. Both parties agree to buy or sell an asset at a set price on a specified date in the future.

FeatureDescription
NatureStandardized contract
Trading PlatformExchange-traded (e.g., NSE, BSE)
StandardizationFixed terms (quantity, quality, date)
RiskLower risk due to exchange regulation
SettlementDaily mark-to-market settlements

Futures reduce the counterparty risk as the exchange guarantees the contract’s performance. They are widely used by institutional investors and traders.

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3. Options

An option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price before or on a specified date. The seller of the option, however, is obligated to fulfill the contract if the buyer chooses to exercise it. There are two main types of options:

  • Call Option – Right to buy an asset at a fixed price.
  • Put Option – Right to sell an asset at a fixed price.
FeatureDescription
NatureGives right but not obligation
TypesCall Option (buy), Put Option (sell)
Trading PlatformExchange-traded or OTC
RiskBuyer’s risk limited to premium paid
UseHedging, speculation, income generation

Options are highly flexible instruments that allow investors to manage risk and create tailored investment strategies.

Exchange-Traded vs OTC Derivatives

Derivatives can be traded in two main markets — exchange-traded markets and over-the-counter (OTC) markets. Both have different characteristics in terms of regulation, risk, and liquidity.

Basis of DifferenceExchange-Traded DerivativesOTC Derivatives
Trading PlatformOrganized exchanges (e.g., NSE, BSE)Private agreements between parties
StandardizationStandardized contractsCustomized contracts
RegulationRegulated by financial authoritiesLess regulated
Counterparty RiskMinimal due to clearing houseHigher risk due to direct dealing
LiquidityHighly liquidLess liquid
TransparencyHigh, as prices are publicLow, as contracts are private

While exchange-traded derivatives are preferred for transparency and lower risk, OTC derivatives offer flexibility for customized financial needs.

Importance of Derivatives in Financial Markets

Derivatives play an essential role in stabilizing and strengthening the financial system. Their key importance includes:

BenefitDescription
Risk ManagementProtects against adverse price movements (hedging).
Price DiscoveryHelps determine the future prices of underlying assets.
LiquidityEnhances market activity and participation.
LeverageAllows traders to take large positions with smaller capital.
Arbitrage OpportunitiesEnables profit from price discrepancies across markets.

However, derivatives must be used carefully, as excessive speculation can lead to significant financial losses.

Derivatives Vs Exchange Traded Derivatives

The derivatives market is a cornerstone of modern financial systems, helping investors manage risk and discover fair asset prices. Instruments like forwards, futures, and options allow businesses and traders to hedge, speculate, and optimize returns.

While exchange-traded derivatives offer safety and transparency, OTC derivatives provide customization and flexibility. A balanced understanding of both types is crucial for effective risk management and financial planning.

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FAQs

Q1: What are derivatives in finance?
A1: Derivatives are financial contracts whose value depends on the price of an underlying asset such as a stock, commodity, currency, or bond. They are used for hedging, speculation, and arbitrage.

Q2: What is the difference between forwards and futures?
A2: A forward is a private, customized contract traded in the OTC market, while a future is a standardized contract traded on regulated exchanges with lower counterparty risk.

Q3: What is an option contract?
A3: An option gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price within a set time. It includes two types — call options and put options.

Q4: What is the main difference between exchange-traded and OTC derivatives?
A4: Exchange-traded derivatives are standardized and regulated, while OTC derivatives are customized, privately negotiated, and carry higher counterparty risk.

Q5: Why are derivatives important in financial markets?
A5: Derivatives help manage financial risk, facilitate price discovery, improve market liquidity, and allow investors to take leveraged positions efficiently.