Investors use financial instruments such as Derivatives & Futures to hedge risks. These risks can be financial liabilities, commodity price fluctuations or other factors. Financially stronger companies or share market dealers accept these risks and use various strategies to make profits out of it.

What are Derivative?

What are Derivatives?

In the investment industry, a ‘Derivative’ is a contract whose price is decided on the basis of one or more underlying assets. The underlying asset can be a currency, stock, commodity or a security(that bears interest). Sometimes, Derivatives are also used for trading in specific sectors such as foreign exchange, equity,treasury bills, electricity, weather, temperature, etc. For example, Derivatives for the energy market are called Energy Derivatives.

Derivatives trading happens in the derivatives market. The entire derivatives market has two main categories – the exchange-traded derivate market and over the counter market. 

According to the Securities Contract (Regulation) Act, 1956 the term “derivative” includes

  1. A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
  2. A contract which derives its value from the prices, or index of prices, of underlying Securities.

What are the types of Derivatives Contracts?

Over the years, the types of derivatives contracts has evolved. The four basic types of Scottish Contracts are Futures, Options, Forwards and Swaps. Different types of derivatives are as follows-

Futures

A futures contract is a special type of forward contract where an agreement is made between two parties to buy or sell an asset at a certain time in future at a particular price.

Futures are common from of fungible contracts traded in the derivatives market.

Options

Options are contracts between a option writer and a buyer that gives the buyer the right to buy/sell the underlying such as assets, other derivatives etc. at a stated price on a given date. Here, the buyer pays the option premium to the option writer i.e the seller of the option. The option writer has to oblige if the buyer decides to exercise the right given through the options contract.

Forwards

In the derivatives market forwards are futures like contracts but the later is only standardised contracts, whereas forwards are customised contract between two parties wherein the settlement happens on a specific date in the future at a price agreed upon on the contract date. 

Unlike futures, forward contracts don’t involve counter-party risk or mark to market payment. It is a contract drawn between parties based on trust.

Swaps

Swaps are private contracts between two parties wherein an exchange of cashflows of the financial instruments owned by the parties takes place. The two commonly used swaps are

  1. Interest Rate Swaps

    This involves swapping cash flows carrying interest in the same currency.

  2. Currency Swaps

    This type of allows the swap of cashflows with principal and interest in different currencies.

How it is different from Equity?

The financial instruments that derive their value from underlying assets such as bonds, commodities, currencies etc. are Derivatives. Whereas, the financial instruments that depend on demand and supply and company related, economic, political or other events. The equities are instruments for investment, while derivatives are used for speculation or hedging purposes.

Who and why they use Derivatives Instruments?

Private or Institutional Investors buy derivative contracts with a purpose. Some of the leading players in the derivatives market are hedgers, speculators and arbitrageurs. These can also be traders investing in futures and options on currency pairs.

Who are Hedgers?

They are the investors who hedge a risk. And, hedging means reducing a risk with a position that will help tackle risky factors or influences arising out of current market conditions. A hedger will try to achieve a position which is opposite to the risk he takes. This investor will try to reduce or eliminate price risk conditions in conditions of price volatility in the market.

Example

For example, an investor intends to purchase 1000 shares of company ‘’ABC’’, but also wants to ensure this long position against market trend, especially in times of high volatility. Consequently, he should take short position of the same amount of ‘’ABC’’ futures to form a hedge. Such action would reduce his exposure to unfavorable situations or events that cause influence upon the whole market.

What do Speculators do?

Speculators invest in the derivatives markets by constantly studying the price movements and taking a position that gives them maximum gains. Their intention is primarily to make maximum profits. Compared to Hedgers, they tend to take a higher risk which can lead to maximum returns or huge loss in the markets. Speculators have to predict the future trends in the market as accurately as possible to place themselves in the right position in the market.

Speculators are the ones who wish to make greater profit with short-term investments. To do so, they provide future forecasts on the basis of fundamental as well as technical analysis. The speculators keep track of the fast moving trends from fluctuating interest rates to public statements by key people and predict the direction in which market will go.

The portfolio of speculators is huge and diversified and involves high net worth investors.

So, what is the role of Arbitrageurs?

Arbitrageurs operate in a swift manner with almost instant decisions being made to earn positive gains without taking any risk. They increase the liquidity in the market by grabbing the time-bound arbitrage opportunities in the market and trading the derivatives instruments immediately. With arbitrageurs, the investors don’t lose money, earn positive gains and trade with no risk. Arbitrageurs take advantage of the price differences that exist for a share in different markets for a limited time.

FAQ

What are the advantages and disadvantages of Derivatives?

Derivatives are highly traded financial contracts, often used for speculation and hedging. Like for any investment instruments, these highly leveraged derivative products have quite a few advantages and disadvantages.

Advantages of derivatives

  • Traders purchase derivates as a hedge against risk exposure
  • They function as a price discovery mechanism like, the spot price of futures contracts are often used to determine commodity price trends
  • Derivatives contribute to market efficiency by eliminating arbitraging opportunities
  • These highly leveraged contracts allow investors to magnify portfolio exposure
  • There are many variations of passages

  • Derivatives are complex trading instruments
  • Due to extremely risky nature, derivatives are widely used as tools of speculation
  • The sophisticated design of the product makes the pricing method complex
  • The high volatile nature can result in a potentially huge loss
  • Involves counter-party risk
  • What are the risks of Derivatives?

    Trading derivatives involves the following risks.
    Market risk: Traders use technical analysis, historical data to understand general market risks
    Counter-party risk: Counter-party risk arises if any of the parties involved (buyer, seller, or dealer) defaults. This risk rises manifold for the contracts sold in the OTC platform
    Liquidity risk: Traders may face liquidity risk issue when they try to exit a contract before maturity if it is difficult to close the position or the current bid-ask spreads are significantly large
    Interconnection risk: Interconnection risk refers to the relation between different derivative contracts and dealers since it impacts a particular trade
    Derivatives trading involves high risk. So, you need to find effective risk management techniques to trade in the derivatives market.

    Are Derivatives the same as futures?

    Derivatives include swaps, futures contracts, options, and forward contracts. Derivatives refers to financial contracts drawn between two or more parties on an underlying asset. Typically, underlying assets in derivatives are securities, currencies, indexes, and commodities.

    Are Derivatives low risk?

    Derivatives are used for hedging to lower risk exposure on various underliers. however, trading alone in derivatives involve risk such as market volatility, counter-party risks, interconnection risks, and the risk of liquidity.