What most people consider to be the entire capital markets, is just the cash segment of the market. The derivatives segment of the market often goes unnoticed but is larger than the cash segment. In 2018, the derivatives to cash market ratio in India was 29.6. As per data from the World Federation of Exchanges Forum, the cash market volume stood at $90.9 billion on the National Stock Exchange as against derivatives volume at $2.7 trillion. In the cash market, the exchange of assets takes place in the present, while the derivatives market deals in buying or selling of future obligations. But what exactly is a derivative market and how does it operate?
Derivatives essentially are contracts that derive their value from an underlying asset. The value of the contract is derived from an asset such as stocks, commodity or currency and hence called as derivatives. Derivatives can be used for speculation as well as hedging. Unlike cash market where even single shares can be traded, derivatives are traded in lots.
There are two major ways of derivatives trading—over the counter derivatives and exchange-traded derivatives.
- – Over the counter derivatives are contracts traded between private parties and the information about the trades are rarely made public. The OTC derivativesmarket is the largest market for derivatives. The contracts in OTC derivatives trade is not standardised and the market is unregulated. Products such as swaps, forward contracts and other complex options are traded in the OTC derivatives The participants in the OTC market are large banks, hedge funds and similar entities.
- – The OTC market is largely run on trust, but what if someone wants to participate in derivatives trading in a relatively safer environment? The exchange-traded derivativescontracts are traded in standardised forms through specialised derivatives The exchange acts as the intermediary and charges an initial margin to eliminate counterparty risks.
While the OTC and exchange-traded derivatives are the two popular ways to trade in derivatives. Beyond the ways of derivatives trading, let us understand the various products for derivatives trading.
- – Forward contract:When a buyer and seller enter into a contract to trade in an asset on a future date at a price decided in the present, it is known as a forward contract. The contract is closed when the buyer pays and the seller gives the asset and the profit and loss are decided by the movement in the actual price of the asset during the contract. Forward contracts are generally traded in the OTC segment and the details of the contract are kept private.
- – Futures contract: The futures contracts are similar to forward contracts, with the difference being standardisation and the way of trading. Futures contracts are standardised contracts and traded through derivativesexchanges with the settlement on a daily basis. Unlike the forward contract where the profit or loss is decided on the day the contract is settled, with the futures contract the profit/loss is decided and settled on a daily basis.
- – Options contracts:The options contract gives an entity the right, but not the obligation, to buy or sell an asset at an agreed price on a future date. If the option gives the right to buy the asset, it is known as a put option. If the options provide the right to buy the asset, it is known as a call option.
- – Swap: These are entirely a different type of derivatives. Swaps are contracts to exchange cash flows on a future date based on the value of the underlying assets. Typically, there are interest rate swaps, currency swaps and commodity swaps.
Derivatives trading with the various derivative products can be used for hedging as well as for speculation. Large manufacturers often use the derivatives market for hedging against the cost of input commodities. For instance, a hair oil manufacturer would trade in copra futures or even forwards to ensure a stable price for the commodity all year round. Derivatives trading is also a popular option for speculators as they are able to take large positions with relatively little capital deployment. Unlike the cash segment, derivatives trading is highly leveraged, which magnifies the profit and loss for people speculating in the market.
Derivatives trading has its origin in commodity trading as it was not always possible to move bulky commodities like securities. Subsequently, derivatives trading became popular due to huge earning potential and hedging by entities consuming commodities.