Derivatives are financial instruments/contracts that derive value from the underlying assets. These are widely used to speculate and make money, while some use them to mitigate and transfer risk. This article focuses on derivatives, their types, and their advantages.
Any financial contract that derives its value from an underlying asset such as stocks, commodities, currencies etc., is known as a Derivative. They are set between two parties or more, where the derivative value is derived from price or value fluctuations of the underlying assets.
You can use derivatives to hedge a position, speculate on the directional movement of an underlying asset, or leverage holdings. Derivative trading takes place over the counter or via an exchange.
Over-the-counter trading occurs between two parties and isn’t by a central authority. Moreover, two-private parties agree on the contract, which is susceptible to counterparty risk. The risk here means the possibility of one of the parties defaulting on the derivative contract.
Derivatives Meaning:
Financial instruments deriving their value from the underlying assets are called derivatives. Originally, the underlying corpus is created that may consist of one security or a combination of different securities.
The underlying asset’s value is bound to change as the value of the underlying assets keeps fluctuating continuously. Generally, stocks, currency, bonds, interest rates and commodities form the underlying assets.
The derivatives market can be classified into two parts:
Exchange-Traded Derivatives
The market managed and regulated standardized futures and options contracts, thus trading on a recognized exchange. These contracts have less risk of default for the investor. Both parties must deposit an initial payment when entering the contract.
Over the Counter (OTC)
These are private agreements between investors, and such contracts do not trade on any exchange, nor do they have any intermediaries. These are not standardized contracts, and parties can easily modify and customize the contract terms.
Participants In Derivatives Market:
There are four participants of the derivatives market –
Hedgers:
Hedgers are risk-averse traders who aim to secure their investment portfolio against market risk and price fluctuation. They assume an opposite position in the derivatives market. By doing this, they transfer the risk of loss to those others who are ready to take it. In return for the hedging available, they must pay a premium to the risk-taker.
For instance, suppose you have 100 shares of ABC company priced at Rs 120. You aim to sell these shares after three months. However, you don’t want to lose money due to a fall in the market price. You also don’t want to lose an opportunity to earn profits by selling them at a higher price in the future. Here, you can buy a put option by paying a nominal premium to help with the above requirements.
Speculators:
Speculators take the risk in the derivative markets. They embrace risk to make profits and have an opposite point of view compared to the hedgers. This opinion difference helps them make huge profits if the bet turns correct.
For instance, suppose you bought a put option to secure yourself from a decline in stock prices. Your counterparty, the speculator, will bet that the stock price will not decline. If the stock price doesn’t fall, you won’t exercise your put option; therefore, the speculator keeps the premium and makes huge profits.
Margin Traders:
A margin means the minimum amount you need to deposit with the broker to participate in the derivative market. It reflects your wins and losses daily as per market movements.
For example, imagine that you buy 200 shares of XYZ Ltd of Rs 1000 each for Rs 2 lakhs in the stock market. However, in the derivative market, you can own a three times bigger position, i.e., Rs 6 lakhs with the same amount.
Arbitrageurs:
Arbitrageurs use low-risk market imperfections to make profits. Arbitrageurs buy low-priced securities in one market and then sell them at a higher price in another market. It only happens when the same security is quoted at different prices in different markets.
For example, suppose an equity share has a stock price of Rs 1000 in the stock market and Rs 1050 in the futures market. They would buy the stock at Rs 1000 in the stock market and sell it at Rs 1050 in the futures market.
Why Investors Enter the Derivatives Market: The Advantage
Other than making profits, there are more reasons for using derivative contracts. Here are the benefits of investing in derivatives:
- Safeguard against market volatility: Price fluctuations of an asset may increase your probability of losses. Look for products in the derivatives market that will help shield yourself against a decline in the price of the stocks you own. Moreover, you may buy products to safeguard against a price rise in the case of stocks.
- Arbitrage advantage: It involves buying a commodity or security at a lower price in one market and selling it at a high price in the other market. This way, you benefit from differences in the commodity prices in two different markets.
- Park surplus funds: Some individuals use derivatives to transfer risk. However, others use it for speculation and to make profits. Here individuals can take advantage of the price fluctuations without selling the underlying shares.
Types of Derivatives:
Forwards and Futures
These are financial contracts that obligate the contract’s buyer to buy the asset at a predefined price on a particular future date. Both futures and forwards are the same in nature. However, forwards are a bit flexible contracts as the parties can customize the underlying commodity, commodity quantity, and the transaction date. In contrast, futures are standardized contracts traded on the exchanges.
Options
Options give the buyer of the contracts the right, but there’s no obligation to buy-sell the underlying asset at a predetermined price.
Swaps
These are derivative contracts that allow the exchange of cash flows between two parties. The swap is the exchange of a fixed cash flow for a floating cash flow. The most popular swaps out there are interest rate swaps, commodity swaps, and currency swaps.
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