Financial derivatives are contracts whose value is derived from the underlying asset. Hedgers and speculators widely use these contracts to take advantage of market volatility. The buyer of the contract agrees to buy the asset at a specific price on a specific date. Similarly, the seller also enters into one such contract. The different types of derivatives include futures and options, forwards and swaps. This article covers in detail what financial derivatives are, how it works, types and the different players in the derivatives market.
What are Financial Derivatives?
Derivatives are financial contracts. The value of financial derivatives is dependent on the underlying asset. The assets can be stocks, bonds, commodities, currencies, etc. The value of the underlying asset changes with the market movements. The key motives of a derivative contract are to speculate on the underlying asset prices in the future and to guard against the price volatility of an underlying asset or commodity.
To better understand a financial derivative, let us take an example of Company ABC. You are certain that the share prices of Company ABC are likely to go up. You can buy a derivative contract by placing an accurate bet to leverage the price movement. Furthermore, derivative contracts can also act as a cushion for your investment to limit losses.
Taking another example, derivative contracts are used to fix the price of a commodity to minimise losses. For instance, dealing in the commodities market doesn’t necessarily involve the physical delivery of the commodity.
To elaborate, a futures contract for onions doesn’t involve buying and selling onions. The value of the contract is derived from the cost of buying and selling onions.
Therefore, derivatives aim to create a balanced exchange rate for assets. Hence, they are popular options to hedge against price volatility.
How Does a Derivative Market Work?
Trading in the derivatives markets is more or less the same as dealing in the cash segment of the stock market. You will require a trading account to deal in derivatives.
Trading in the derivatives market is through Exchanges and Over the Counter (OTC).
- Exchange-Traded Derivatives: Contracts that take place through a broker are exchange-traded derivatives. Futures and options are exchange-traded derivative contracts. When you purchase a stock option, you will be purchasing the option instead of the security.
- Over the Counter Derivatives: Contracts that take place directly between two parties are over the counter derivative contracts. Forwards and swaps are over the counter contracts. As a result, these contracts are customised to suit the requirements of both parties to the contract.
Furthermore, financial derivative contracts are not risk-free. They come with an inherent risk of market volatility. Therefore, it is risky to trade in the derivatives market without proper hedging mechanisms.
Who are the Participants in a Derivative Market?
Derivatives trading requires a good understanding of the stock market. Knowledge and time to track the stock market movements are primal for participating in the derivatives market. Therefore, derivatives are not everyone’s ball game.
Following are the participants in the derivatives market:
- Hedgers: The main focus for hedgers is protection. Often known as risk-averse traders. Hedgers like to protect themselves from possible price fluctuations in the future. Hedgers are active in the commodities market where the price fluctuations are rapid. Futures and options trading can offer them the much-needed price stability in such instances.
- Speculators: Speculators are risk-takers who wish to earn good profits. They constantly monitor the markets, the news, and any other information that could affect their trading. As a result, speculators place an educated wager on the underlying asset’s price. In simple terms, speculators seek to purchase an asset at a lower price in the short term while betting on bigger returns in the long run.
- Arbitrageurs: Arbitrageurs take advantage of the price difference of the same asset across different exchanges. Arbitrageurs buy securities at a low cost in one market and sell them at a higher price in a different market.
- Margin Traders: Brokers in the derivatives market require a deposit/ margin amount from investors. Margin amount is a minimum amount that investors have to deposit with the broker to trade in the derivatives market. As a result, the trader can maintain a sizable outstanding position.
Types of Financial Derivatives
The most popular types of Financial Derivatives are:
Futures are a type of derivatives contract where the buyer and seller enter into an agreement to fix the quantity and price of the asset. The agreement has the quantity, price and date of the transaction mentioned. Upon entering into the contract, the buyer and seller are obligated to fulfil their duty regardless of the asset’s current market price. Futures contracts are popular for hedging risk and speculation. However, the main purpose is to fix the price of the asset against volatility.
With a futures contract, you can take advantage of the margins. A margin requirement is a minimum amount that you must deposit in order to trade futures on an exchange. The higher the leverage, the lower is the margin.
For example, if a commodity’s exchange margin is set at 5%, the leverage is 20 times. This indicates a deposit value of INR 5; you can trade for INR 100. The trader must repay the entire amount when the contract expires. As a result, higher leverage indicates high risk.
Options also derive their value from the underlying asset. The option holder is not obligated to buy or sell the asset on expiry. Following are the two types of options:
- Call Option: The buyer of a call option has the right, but not the obligation, to purchase the asset at the stated price on the specified date. For example, if you buy a call option on Company ABC to buy 100 shares at INR 200 on a certain date. The share price of Company ABC has plummeted to INR 150 on the expiration date.
As a result, you are unwilling to execute the contract since it is a loss proposition. You have the option not to purchase the stock. You will just lose the premium paid to enter the contract in such a case. As a result, instead of losing INR 5,000, you will just lose the premium you paid.
- Put Option: A put option holder has the right but not the obligation to sell the underlying asset at a specific price on a specific date. Suppose you acquire a put option on a Company ABC to sell 100 shares at INR 200 on a certain date, for example. The share price of Company ABC has increased to INR 250 on the expiration date, and you are unwilling to execute the contract since you would lose money. You have the option of not selling the stock and saving INR 5,000.
Forward contracts are similar to futures contracts. The contract holder is under the obligation to fulfil the contract. However, these contracts are not standardized and do not trade on the exchange. Forward contracts are over the counter contracts. As a result, these are customized contracts to suit the requirements of the buyers and sellers (parties to the contract).
Swaps are derivative contracts that help two parties to exchange their financial obligations. Corporates use swap contracts to minimize and hedge their uncertainty risk of certain projects. There are four types of swaps. Namely, interest rate swaps, currency swaps, commodity swaps and credit default swaps.
The most popular type of swap is a credit default swap. A credit default swap provides insurance from a debt default. The buyer of the swap gives the seller the premium payments. In case of a default, the seller will pay the buyer the face value of the asset. At the same time, the seller will get possession of the asset.
Why Do Investors Choose Financial Derivatives?
Following are the key reasons why investors choose financial derivatives:
- To address market volatility: Financial assets are highly volatile. The price fluctuations can often lead to heavy losses. You can leverage the financial derivatives to minimise your losses. Suitable derivatives contracts can help shield you from price falls as well as price rise, as the case may be.
- Arbitrage opportunities: Derivative contracts have good arbitrage opportunities. Arbitrage involves buying an asset at a low price in one market and selling it at a high price in another market. The difference between the prices is the profit that you will make.
- Access to different assets and markets: Derivatives can help businesses gain access to assets or markets that might otherwise be unavailable. For example, interest rate swaps allow a corporation to get a better interest rate than it could get from direct borrowing.
Advantages and Disadvantages of Financial Derivatives
- Lock in Prices: With derivatives, investors can lock in the prices of the assets. If they expect the asset prices to go down in the future, through derivative contracts, they can lock in the present prices.
- Hedging: Derivatives are popular for hedging. Individuals can enter into a derivative contract where asset value moves in the opposite direction to the asset value they already own.
- Leverage: Derivatives are leveraged products. Investors can get access to higher capital through leverage, i.e., they can get access to more money than actual cash in hand.
- High Risk: Derivatives are high-risk investment options. Their high volatility may lead to huge losses.
- Leverage: Leverage can work as an advantage as well as a disadvantage. If the asset prices move in the opposite direction than your anticipation, the losses can be huge.
- Counter-Party Risk: Some derivative contracts are over-the-counter contracts. For such contracts, the counterparty default risk is high.