A derivative market is a platform where financial securities that fall under the category of derivative contracts are traded. A derivative market is specially designed to facilitate the trading of all derivatives. Derivative markets include both exchange-traded derivatives and Over-the-Counter (OTC) derivatives. A derivative is a type of financial instrument based on the value of an underlying asset, including stocks, commodities, and currencies. Derivatives take the form of a financial contract between two or more parties. The four main types of derivative contracts include forwards, futures, options, and swaps. Derivatives are traded only on the derivative market, and investors use derivatives to hedge their risk.
Derivative Markets function through contracts formed between parties by betting on the forthcoming value of an underlying asset or group of assets. A derivative contract is purchased based on the price predictions of the underlying asset. In order to undertake derivatives trading, a demat account, a trading account, and a margin maintenance amount are essential. Using these three requisites, participants purchase in derivatives contracts. Derivatives trading in a derivatives market occurs through exchange or over-the-counter trading. Derivative trading through an exchange is governed by a regulatory body, whereas over-the-counter trading is not regulated by any authority. The derivative market participants enter into financial contracts with other participants by placing bets on the predicted prices of the underlying assets. In a derivative market, there are four participants, namely speculators, arbitrageurs, hedgers, and margin traders. These four participants in the derivatives market are classified according to their trading motives.
What is Derivative Market?
A derivative market is a financial platform that facilitates trading all financial instruments that fall within the derivatives category and whose values are derived from underlying assets. The derivatives market includes both exchange-traded derivatives and over-the-counter derivatives. Derivative markets handle the trading of all four types of derivatives, including futures, swaps, options, and forward contracts. All derivative markets comprise four main participants, including hedgers, speculators, arbitrageurs, and margin traders. Participants turn to the derivatives market mainly to hedge against risks and to take advantage of arbitrage.
For instance, a farmer who produces cotton enters into a derivative contract with a textile miller. The farmer’s objective in entering the contract is to mitigate the risk of a fall in the price of cotton. The contract ensures that he is paid a reasonable predetermined amount on a fixed future date, irrespective of price fluctuations. For the textile miller, the contract serves as a hedge against the impact of a rise in the price of cotton. The contract locks the price at an amount that is agreeable to both parties.
How do Derivative Markets work?
The derivatives market works as a financial contract between two or more parties. The derivatives market functions based on the bets placed on the future prices of the underlying assets. Derivative contracts can be purchased on the derivatives market, which is either through exchanges or over-the-counter transactions.
There are two main classes of derivative contracts, namely, “lock” and “option.” A lock binds the parties entering the contract to terms that are decided upon by the involved parties. An option gives the holders the right to purchase or sell the predetermined security at a set price on or before a fixed date. Options, however, are not obligatory like locks. Market participants, including hedgers, speculators, arbitrageurs, and margin traders, enter into derivative contracts with other market participants depending on their investment objectives.
For example, a carrot farmer enters into a “lock” contract with a vegetable seller. The farmer’s objective is to hedge against a drop in the prices of carrots. By entering into a “lock” contract, the vegetable seller agrees to purchase a fixed quantity of carrots for a fixed price on a set date. The vegetable seller’s objective in entering the contract is to hedge against the possibility of an increase in the price of carrots. In this manner, each participant enters into a derivative contract depending on their needs and investment objectives.
Market participants can buy or sell derivative instruments through an exchange or over-the-counter transactions. Exchange-based transactions in the derivatives market are regulated by authorized bodies, whereas contracts made through over-the-counter transactions are not regulated by any authority. Over-the-counter transactions in the derivatives market, thus, pose more risk.
The underlying assets in a derivative market include stocks, bonds, currencies, commodities, etc. Predicted price fluctuations in the underlying asset determine the prices of the derivatives.
The four main steps in trading in a derivatives market are listed below.
- Conducting market research
The first step to trading in a derivatives market is conducting proper market research. Derivatives contracts are bets placed on the predicted value of underlying assets. Therefore, the strategies applied to the derivatives market differ from that applied to stock markets, as derivative contracts are based on the expected change in the asset prices and not their current market price.
- Opening a demat and trading account
The second step in trading in the derivatives market is opening a demat and trading account. These two are requisites to undertaking trades in the derivatives market. The accounts can be created online in any brokerage of the investor’s choice. Once the two accounts are set up, the participants can enter into derivative contracts, either through an exchange or through over-the-counter transactions.
- Maintaining a margin balance
The third step to keep in mind while trading in the derivatives market is maintaining a margin amount. A margin amount is essential in derivatives trading and cannot be withdrawn from the account until the derivative contract’s expiry date.
- Undertaking desired trades
The fourth and final step in trading in the derivatives market is undertaking the desired trades. The participants can opt for lock or options contracts depending on the investment goals. They can also choose from various derivatives available, including forwards, options, swaps, and futures.
Who are the four participants in Derivative Market?
A Derivative Market comprises four main participants. The four participants in a derivative market are listed below.
1. Speculators
Speculators are traders who take huge risks by making predictions about value of assets. Speculators make speculations about market price movements and enter into derivatives contracts based on these speculations. Speculators have a high-risk appetite and are driven by the desire to make higher returns. They believe that the higher the risk involved, the greater the chances of making high returns. Speculators are key in providing liquidity to the market as they are high-risk takers. Examples of speculators include day traders and position traders. As the name suggests, day traders make returns through price fluctuations with the trading hours in a day. Position traders, on the other hand, make long-term speculations that take place over weeks or even months.
2. Arbitrageurs
Arbitrageurs are traders who purchase securities from one market and sell them in another. Arbitrageurs are traders with low-risk appetites. Arbitrageurs make use of securities that are simultaneously being sold in more than one market at different prices. Arbitrageurs take advantage of the pricing inefficiencies that are present in one market, wherein an asset is priced either higher or lower than it should be. When such a price difference exists, arbitrageurs purchase them from the market where they are priced lower and sell them in the market where the asset is priced higher. In this manner, arbitrageurs help to limit such inefficiencies. Arbitrageurs are commonly experienced investors with experience and know-how about various assets and markets.
3. Hedgers
Hedgers are traders who invest in the derivatives market to mitigate risk. Hedgers are risk-averse investors who use derivative instruments to reduce the losses that market volatility entails. Hedging helps to counterbalance the risks involved in investing in assets such as stocks, bonds, commodities, or currencies. Through hedging, the investors protect their assets by entering into an exact opposite trade in the derivative market. In this manner, the hedger transfers the risk to other market participants who are risk-seekers and hedge against losses. The risk-seekers, in turn, are those investors and traders willing to take on the risk. Hedgers commonly include producers, farmers, and wholesalers who face losses if their commodities’ prices fall.
4. Margin Traders
Margin traders are speculators who aim to make quick profits through the derivatives market. Margin traders use leveraging to make purchases that are beyond the means of their current financial status. Their trading technique is known as margin trading. Margin trading refers to the trading technique where the investors only pay a fraction of the total amount payable initially. A small fraction of the total amount payable is as a deposit, known as the margin balance. Using margin trading, investors can make more significant trades than what their financial capacity can afford. Margin trading is a technique that is distinctive to the derivatives market. Examples of margin traders include day traders and position traders.
What are the four different types of Derivatives?
The four different types of derivatives are listed below.
1. Futures Contract
A futures contract is an agreement between two parties that gives the holder the right to purchase or sell the underlying asset for a specified price on a specific date. Futures contracts are obligatory, and therefore binding on the two parties. Futures contracts are standardized derivative contracts that trade on exchanges. Traders use futures contracts to hedge against risks due to price fluctuations in the underlying assets. Futures contracts promise the holder a predetermined buying or selling price, which remains unaltered irrespective of the market volatility, and therefore shields them from risk.
Futures contracts are traded in all major stock markets, including the Indian Stock Markets like the Bombay Stock Exchange and the National Stock Exchange of India. The Securities and Exchange Board of India (SEBI) regulates all the futures contracts in India.
Futures contracts are based on any type of asset or commodity, including agricultural goods, energy-based commodities, stocks, bonds, etc. For example, an agricultural future contract is based on an agricultural commodity such as wheat or cotton. A bakery owner buys a futures contract for wheat, for 100 kg at Rs 40,000, with an expiry date of December 23, 2022. The bakery owner makes this purchase because he fears the wheat price will increase. By purchasing this futures contract, he is assured 100 kg at Rs 40,000 irrespective of the price changes.
2. Swaps Contract
Swaps are derivative contracts with two holders who exchange the obligatory financial terms of the contract. Swaps are not sold through exchanges as they are tailor-made to suit the requirements of the two participating parties. Commonly used swap contracts include interest rate swaps, currency exchange rate swaps, mortgage bond swaps, etc. Swap contracts help investors and traders to exchange one type of cash flow with another.
For example, let us assume that a company, A borrows a loan of Rs 20 lakhs at a variable interest of 5% now. Since the loan is of variable interest, A worries about the increasing interest rates and thus wishes to switch to a fixed interest rate. In such a situation, A can approach another company B, which has a fixed-interest loan at 6%. B is willing to exchange the payments from the fixed rate loan of 6% for the payments from the variable interest loan of 5%. A will have to pay B the percentage difference of 2% on the principal amount of 20 lakhs if the variable interest rate drops to 4%. However, B will have to pay A the percentage difference of 1% if the variable interest rate increases from 5% to 7%. In this manner, A can switch from a variable-interest loan to a fixed-interest one.
Traders enter into swap contracts to shift from variable interest rates to fixed interest rates. It can also be used to switch from fixed interest rates to variable interest rates. Swap contracts come in handy, mainly when lenders are reluctant to lend more credit to companies. Swap contracts are traded on the Indian stock market.
3. Options Contract
Options contracts are derivative contracts that give buyers the right to buy or sell the underlying asset on or before a specified date. Options contracts, however, are not obligatory wherein the buyer is bound to fulfill the terms of the contract. Like futures contracts, options contracts also form an agreement between two parties. The only difference between a futures contract and an options contract is that the holders of options contracts are not under any obligation to buy or sell the asset as deemed by the contract. Options contracts only provide their holders with the opportunity to buy or sell an asset at a specific price, should they so desire. Option contracts protect traders from risks while allowing them to avoid falling through with the contract if the contract terms do not seem attractive later. Options help traders to hedge against market price fluctuations.
For example, an investor, X, owns 100 shares in a company, AB. Let us assume that the price of each share is Rs 100. X is worried about price fluctuations that can cause a decline in his stock price, so he decides to buy an options contract. Through an exchange, X buys an option that allows him to sell the 100 shares for Rs 100 each on or before a specified date. Let us assume that the stock price falls to Rs 80 per share before the contract’s expiry date. Using the option, the option holder gets to sell his shares at the predetermined price of Rs 100 per share. Assuming that the options contract costs the buyer Rs 1000, this is the only cost incurred by the option holder. Without the options contract, he would have had to sell his shares for Rs 80 each, incurring a loss of Rs 2000.
Options also help speculators in speculating the forthcoming market prices. Options contracts are traded in all leading stock exchanges in India, including the BSE and the NSE.
4. Forward Contract
Forward contracts are derivatives that are similar to future contracts but are sold over the counter rather than through an exchange. Forward contracts are customized agreements whose terms are made to cater to the needs of the buyers and sellers. Since they are sold over the counter, they encompass more risk to both the involved parties. Forward contracts do not fall under the jurisdiction of regulatory authorities such as the SEBI in India and the SEC in the United States, thereby making them riskier than futures contracts. Forwards contracts involve counterparty risks when one party cannot fulfill their obligations as deemed by the contract.
Forward contracts, like futures contracts, help hedge as well as speculate. Forward contracts shield holders from incurring huge losses apart from offering the two parties the means to customize the contract according to their specific needs. Since futures contracts are exchange based, they cannot be altered to suit the needs of the two parties. In situations where there’s a need to customize the derivatives contract, the forward contract works better. Forward contracts are traded on all major stock exchanges, including the Indian stock exchange.
For example, a company can purchase a forward contract for oil for Rs 3800 a barrel with an expiry date of November 23, 2020, from an oil seller. This contract ensures that regardless of the price fluctuations, the company can buy oil for Rs 3800 a barrel on the set date. However, since the contract is not exchange-based, there is a slight chance that the seller will not stick to the terms of the contract.
What type of derivatives is best to use in the Indian Derivative Market?
No one type of derivative is best to use in the Indian Derivative Market. All four types, including futures, forwards, options, and swaps are available for trading in the Indian Derivatives Market. Investors and traders must choose the type that works best for them, depending on their goals and risk tolerance. Each type of derivative comes with its own pros and cons, and they can encompass varying degrees of risk. After careful thought and research, every investor must find the type of derivative that works best for their needs and goals.
What are the advantages of the Derivative Market?
The five main advantages of the derivatives market are listed below.
- To hedge securities against risk.
One of the key advantages of the derivatives market is that it allows traders to hedge their securities. By hedging, traders can protect themselves from huge losses from market volatility.
- To transfer risk to other market participants.
The transference of risks onto the risk seekers is another critical advantage of the derivatives market. The derivatives market comprises risk-averse and risk-seeking traders as participants, making it possible for the risk-averse traders to pass on the risk to the risk seekers, mainly through speculations.
- To lock prices from fluctuations.
Another main advantage of the derivatives market is that it allows the holders to lock the prices of the underlying assets. Once the contract is bought, the asset’s price cannot be altered, irrespective of the price changes in the market. The feature is handy to traders, including producers and farmers, who face huge losses when commodity prices fall.
- To make profits through arbitrage.
Making profits through arbitrage is another advantageous feature of the derivatives market. Apart from offering profits to the traders, arbitrage also helps to fix market pricing inefficiencies in the market, wherein securities are priced lower or higher than they should be.
- To mitigate risks cost-effectively.
The derivatives market gives traders and investors a cost-effective way of hedging, as derivatives contracts can be purchased using the margin balance in the account. The margin balance is only a tiny percentage of the total cost of the derivatives contract.
What are the disadvantages of the Derivative Market?
The four commonly pointed-out disadvantages of the derivatives market are listed below.
- The risk involved.
The derivatives market is not entirely risk-free. Over-the-counter contracts are considered even riskier than exchange-based derivatives, primarily because no authority regulates them.
- The effect of market volatility
The derivatives market is volatile. For example, derivative contracts are sensitive to changes in interest rates or the expiry periods of the contracts, making the derivatives market volatile.
- The complex functioning of the derivatives market
The functioning of the derivatives market can seem complex to many traders and investors because derivatives are contracts based on the value of an underlying asset. However, trading in the derivatives market is not done directly through the underlying asset.
- The counterparty risks associated with derivatives
Derivatives are associated with a greater risk of counterparty risks. Counterparty risk refers to the risk of the other party in the contract not fulfilling their obligations concerning the deal. Since OTC derivatives do not come under the jurisdiction of securities regulatory bodies, the counterparty risk is more significant for OTC derivatives.
Is it a smart idea to proceed with a derivative contract?
Yes, it is smart to proceed with a derivative contract, provided you have a clear investment strategy and know how the derivatives market functions. Derivatives contracts help hedge securities against risks and price fluctuations. However, derivatives contracts are not entirely risk-free. Over-the-counter derivative contracts involve more counterparty risks than exchange-based ones. Over-the-counter derivatives also do not come under the jurisdiction of any regulatory bodies or authorities. Therefore, proceeding with a derivative contract is advisable only after weighing all its pros and cons.
