What are derivatives in finance and trading? Derivatives are financial instruments whose value is dependent on the value of the underlying asset, index, rate, or other financial instrument. It is a contract set between two or more people.
Derivatives can trade at exchanges, forex markets, or over-the-counter markets. Derivatives derive their price from the fluctuations in the price of the underlying asset.
Traders make profits by betting on the future value of the asset. It could provide you with an opportunity to make a profit by simply guessing the future price. However, like any financial instrument, it is not without risk.
Buying and selling of derivatives, which involves financial speculation and risk management is called derivative trading.
Participants in Derivative Markets
Participants in the derivative market can be categorized into four based on their trading motives- speculators, hedgers, margin traders, and arbitrageurs. Let us look into these categories and their motives for entering into the market in detail.
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Speculators
Speculators participate in the market with the primary objective of making a profit from the price movements in the underlying assets. Depending on their market expectations they aim to buy low and sell high or buy high and sell low.
Speculators are willing to take higher risks to earn higher returns potentially. They often use leverage to amplify their exposure to market prices. It is their mindset that differentiates them from other kinds of investors While others may inhibit from taking risks, speculators believe that the higher the risk higher be return. Compared to investors, speculators have shorter investment horizons. Based on short-term market trends and prices, they may enter and exit positions quickly. So, they contribute to the market liquidity.
Hedgers and Derivatives
Hedgers use derivatives to protect themselves from the risk of adverse price movements of the underlying asset. Their primary goal is to eliminate or reduce risk. They use derivatives as a kind of insurance to counterbalance potential losses in their investment portfolios.
To mitigate risk over a long period, hedgers usually employ a long-term perspective. Hedging helps to stabilize cash flows and thereby protect the market against uncertainties. Though they may not contribute to the market liquidity much, they play a crucial role in managing and mitigating the financial market.
Margin Traders
Margin traders are individuals or entities that engage in trading derivates using borrowed funds by opening a margin account. This account allows traders to borrow funds to open larger positions than their initial capital may allow. This is made possible by leveraging, where the trader is required to deposit only a fraction of the total value of the position. It is highly riskier compared to trading with one’s own capital.
Margin traders need to possess higher risk management skills. They should have a proper understanding of risks associated with specific derivative instruments being traded. Margin traders should be careful to set stop-loss orders and monitor margin levels.
As borrowing funds to trade on margin involves interest costs, traders should also consider the interest amount while calculating the profit margin.
Arbitrageurs
Arbitrageurs in derivative trading use the strategy known as Arbitrage. It involves taking advantage of price differences for the same or similar assets across different markets or periods to make a risk-free profit. In the context of derivative trading, arbitrageurs exploit price discrepancies between derivatives and their underlying assets, or between different derivative contracts.
Arbitrageurs closely monitor the prices of related assets or derivative contracts in different markets. They look for situations where the prices of these assets or contracts deviate from their fair value.
When arbitrageurs identify a price discrepancy, they execute a series of trades to exploit the difference. These trades involve buying the undervalued asset or contract and simultaneously selling the overvalued one.
The goal of arbitrage is to make a risk-free profit. By buying low and selling high (or vice versa), arbitrageurs capitalize on market inefficiencies until prices converge to eliminate the discrepancy.
Types of Derivative Contracts
There are diverse types of derivatives available for risk management, speculation, and leveraging a position. There is a continuously growing market catering to diverse needs and risk preferences.
Derivative products can broadly be classified into option and lock. In locking derivatives, the parties are obliged to obey the predetermined terms throughout the contract. On the contrary, option derivatives provide the holder with a choice, but not the obligation, to purchase or sell the underlying security at a designated price on or before the expiration date.
Now, let us see four major derivatives available in the market.
Futures Contracts
A futures contract is a standardized contract between two parties for the buying and selling of an asset at a predetermined price at a future date. These contracts are traded in organized exchanges. The parties involved here are obliged to buy or sell the underlying asset on the determined date.
Futures contracts can be based on a variety of underlying assets, including commodities (such as gold, oil, or agricultural products), financial instruments (like stock indices, interest rates, or currencies), or even specific securities.
Each futures contract has standardized terms and conditions, including the size of the contract, the minimum price movement, and the expiration date. These standardized terms facilitate trading and ensure a level playing field for all participants.
In a futures contract, the position taken by the party that agreed to buy the underlying asset is known as the long position and the position taken by the selling party is called the short position. A contract is settled on a predetermined date either through the physical delivery of the underlying asset or in cash.
Long position holders enter the contract with the expectation that the price will rise whereas short position holders expect the price to fall. Futures markets play a crucial role in price discovery, liquidity provision, and risk management in financial markets.
Forward Contracts
A forward contract is a financial derivative that represents an agreement between two parties to buy or sell an asset at a predetermined future date for a price agreed upon on the trading day. Unlike futures contracts, forward contracts are typically traded over-the-counter (OTC). Meaning they are customized agreements negotiated directly between the buyer and the seller rather than being standardized and traded on an organized exchange.
Forward contracts are highly customizable. The parties can negotiate the terms, including the specific details of the asset, the quantity, the price, and the delivery date. This flexibility allows for customized agreements that meet the specific needs of the parties involved.
Forward contracts are private agreements entered into between two parties, and the terms are not disclosed to the public. This contrasts with futures contracts, which are standardized and traded on public exchanges, providing transparency.
Swaps Contracts
In the context of the derivative market, “swaps” refer to financial contracts where two parties agree to exchange cash flows or other financial instruments over a specified period. Swaps are commonly used for hedging, managing risks, or even as speculative tools.
Swaps are traded over-the-counter (OTC), meaning they are customized contracts negotiated directly between the parties involved. Due to their flexibility and adaptability, swaps are widely used by financial institutions, corporations, and institutional investors to manage various financial risks in their portfolios.
Interest rate swaps and currency swaps are the key types of swaps. Interest rate swaps involve the exchange of interest rate cash flows between two parties who are often referred to as the “fixed-rate payer” and the “floating-rate payer.”
The fixed-rate payer agrees to make periodic fixed interest rate payments to the floating-rate payer. While the floating-rate payer agrees to make periodic variable (floating) interest rate payments to the fixed-rate payer.
Currency swaps involve the exchange of cash flows in different currencies between two parties. In a currency swap, the parties agree to exchange principal and interest payments in different currencies over a specified period. Currency swaps are often used by multinational companies to manage currency exposure. For instance, a company operating in multiple countries might enter into a currency swap to hedge against exchange rate fluctuations.
Options Trading
Options are financial derivatives that provide the buyer with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specified expiration date. It is a significant component of the derivatives market and offers various strategies for hedging, speculation, and risk management.
Let us see in detail about options trading in the upcoming article, as it is a vast and hot topic and we don’t want to dump a lot of information in a day.
Frequently Asked Questions on Derivatives
What are the different types of derivatives?
Future contracts, Forward contracts, swaps, and options are four different types of derivatives available in the market.
What do we call the participants in a derivative market?
Speculators, hedgers, margin traders, and arbitrageurs are the terms usually used for participants in a derivative contract based on their goal.
What are the advantages of derivatives?
- Charges are low compared to other financial instruments like shares.
- It allows you to transfer risk among the participants.
What are the disadvantages of derivatives?
- High risk because of its dependence on market volatility.
- Speculations can go wrong and lead to huge losses.
