In this hypothetical, but extremely common story, Raj and Simran confronted several derivatives. First, they were considering signing a lease. The lease requires that they make a series of fixed payments over a 12 month period, for which they receive the use of the apartment. This is a type of derivative known as swap.
They then chose to enter into an agreement to buy an asset, the house, at later date at a price they agree on in advance. To secure their commitment they offered a collateral deposit. What they did was enter into something similar to a forward or futures contract.
They were offered a mortgage with a fluctuating interest rate but with a cap on the increase in the rate plus an overall lifetime cap.
These caps are forms of options. The options would in effect compensate them for increases in interest rate, thereby helping them, to control some of the risk. The fixed-rate loan alternative allowed them to lock in the rate and, therefore, not to worry about the course of interest rate over the next two months. Alternatively, if they wanted to take advantage of the possibility of the falling interest rates, they could pay INR 5,000/- cash and have the right to pay a lower rate if a lower rate was in effect on the closing date. This is also an option.
Nonetheless, Raj and Simran chose to borrow at a fixed rate and passed up the option to borrow at a lower rate. The loan offered them the right to refinance their mortgage at any time without a penalty. This, too, is an option.
So this ordinary couple, in the course of an extremely common series of family financial decisions, confronted and, in some cases, engaged in derivative transactions. These transactions were made in light of a great deal of consideration of the risk they faced both before and after using these derivatives.