What is a Derivative Market?
What is a Derivative Market?
The derivatives market was introduced in India in the year 2000 and since
then it has been gaining considerable importance like its counterparts
abroad. Like stocks, derivatives are also traded on stock exchanges.
Derivatives are a type of security whose value is derived from the
underlying asset.
These underlying assets may be stocks, bonds, commodities, or currency.
The popularity of derivatives can be easily understood by the daily
turnover in the derivatives segment on the exchange, which is much higher
than the turnover in the cash segment on the same exchange.
Derivative Market
The derivatives are either exchange-traded or traded over the counter
(OTC).
The exchange refers to a formally established stock exchange in which
securities are traded and they have a set set of rules for shareholders.
Whereas OTC is a dealer-oriented market of securities, which is an
unorganized market where trading is done through phone, email, etc.
Derivative trades on the exchange are standardized and regulated.
On the other hand, derivatives contracts constitute a large proportion
of OTC derivatives, but it carries high counterparty risk and is
erratic.
These financial instruments help to make a profit by placing bets on the
future value of the underlying asset. Hence it is called derivatives
because they derive value from the underlying asset.
For example, derivatives contracts are used by wheat farmers and bakers
to reduce their risk.
The farmer feared that any drop in price would affect his income.
So enter the contract to lock in the acceptable value of the given
commodity. On the other hand, Baker enters the contract to reduce his
risk so that he does not suffer loss as the price increases.
Use of derivatives
Derivatives contracts such as futures and options trade freely on exchanges and can be employed to meet a variety of requirements including:
a) protect your securities
Derivative contracts can be used to protect your securities from price
fluctuations.
The shares you hold can be protected on the downside by entering into
a derivative contract.
Apart from this, it also saves you from increasing the share price
that you plan to buy.
b) Risk transfer
It is the most important use of derivatives that helps in transferring
risk from the risk-taker to the risk-taking investor.
A risk-taking investor can enter risky contrast trades to obtain
short-term gains.
Whereas the risk-taking investor can increase the security of his
position by entering into a derivative contract.
c) Benefit from arbitrage opportunities
Arbitrage trading simply means buying low in one market and selling
high in another market.
So with the help of derivatives contracts, you can take advantage of
the price difference in the two markets.
Thus it helps in creating efficiency of the market.
Difference between cash and derivatives market
- In the cash market, we can also buy a share while the minimum lot is fixed in terms of futures and options.
- Tangible assets are traded in the cash market, while tangible or intangible assets are traded on derivative contracts.
- The cash market is used for investment. Derivatives are used for hedging, arbitrage, or speculation.
- In the case of cash markets, a client must open a trading and Demat account, while for futures a customer must open a future trading account with a derivative broker.
- In the case of the cash market, the entire amount is kept in front whereas in the case of futures only margin money is required to be invested.
- When a person buys shares, he becomes a shareholder of the company whereas this is not the case with futures contracts.
- In the case of the cash market, the owner of the shares is entitled to a dividend, while the holder of the derivative is not entitled to a dividend.
Derivatives Market Partners
Participants in derivatives markets can be separated into three
categories -
a) Headers
These are traders who wish to protect themselves from the risk or
uncertainty involved in the price movement.
They try to hedge their position by entering into an exact opposite
trade and pass the risk on to those who are willing to bear it.
By doing this, they try to get rid of price uncertainty.
For example, you have 1000 shares of XYZ Ltd. and CMP is 50 rupees.
You are planning to hold the shares for 6-9 months and you expect a
good change.
However, in the short term, you think the stock may see an
improvement, but you do not want to end your position today as you
are expecting a good chance in the near term.
For example, you can reduce your losses by paying a small price or
premium in an options contract (a part of a derivative strategy).
Also, you will benefit from it whether the price falls or not. This
way you can stop your risk and transfer it to someone who is ready
to take the risk.
b) Speculators
They are very high-risk seekers who anticipate future price activity
in advance in the hope of large and quick gains.
The objective here is to take maximum advantage of price
fluctuations.
They play a very important role in the market by absorbing
additional risk and provide much-needed liquidity in the market when
ordinary investors do not participate.
c) Arbitrageurs
Arbitrage is a low-risk trade that involves the purchase of
securities in one market and sale in another market.
This happens when the same security is trading at different prices
in two different markets.
For example, suppose the cash market value of a share is Rs 100 and
it is trading at Rs 110 per share on the futures market.
An arbitrage (intermediary) inspects it and buys 50 shares for Rs
100 per share in the cash market and at the same time sells 50
shares at Rs 110 per share, thus getting Rs 10 per share.
Types of derivatives contracts
There are four types of derivatives contracts including forwards,
futures, options, and swaps.
Since swaps are complex instruments that we cannot trade on the
stock market, we will focus on the first three.
a) Forward Contracts
They adapt contracts contracted between two parties where they agree
to trade a particular asset at an agreed-upon price and at a
particular time in the future.
These contracts are not exchanged but are traded privately over the
counter.
b) futures contract
These are standardized versions of forwarding contracts that occur
between two parties where they agree to trade a particular contract
for a specified time and price.
These contracts are exchanged.
c) Options
It is an agreement between a buyer and a seller that empowers the
buyer but is not obligated to buy or sell a particular property at a
later date at the agreed-upon price.
Difference Between Forward and Futures Contracts
- Forward contracts are traded over the counter while futures trading is exchanged.
- Forward contract settlement takes place on the agreed date between the parties while futures contract settlement is done daily.
- The cost of forward contracts is based on bid-based spreads while futures contracts have a brokerage fee for buying and selling orders.
- In the case of forwards, they are not subject to market marking. On the other hand, futures are marked for the market.
- Margin is not required in the case of forward market whereas margin is required in futures.
- In a forward contract, the credit risk is borne by each party whereas in the case of futures there is a two-way transaction, so both parties need not worry about the risk.
- Forward contracts are traded on a private basis while futures contracts are traded in a competitive field.
Types of futures
Depending on the underlying asset, a variety of futures
contracts are available for trading.
a) Individual Stock Futures
These are contracts between 2 investors.
The buyer assumes a share at a predetermined future point,
promising to pay a specified price for 500 shares.
The seller promises to deliver the stock at a specified price at
a future date.
b) Stock Index Futures
The underlying asset is the stock index. Stock index futures are
more useful when one speculates on the general direction of the
market rather than the direction of the stock.
It can be used to hedge a portfolio of shares.
c) Commodity Futures
Here the underlying asset is a commodity like gold, silver,
nickel, crude oil, etc.
In India, commodity futures are traded on 2 exchanges ie MCX ie
Multi Commodity Exchange, and NCDEX ie National Commodities
& Derivatives Exchange.
The following are some examples of commodities - pulses, grains,
fiber, oil and seeds, energy, metals, and bullion.
d) Currency futures
These are exchange-traded futures contracts that specify a price
in one currency at which another currency can be bought or sold
at a future date.
These are legally binding and the parties holding the contract
on the expiry date must distribute the currency amount at the
specified amount on the specified date.
e) Interest Rate (Interest Rate) Futures
In this case, the underlying asset is a debt obligation that
operates according to changes in interest rates.
Types of margin requirements
There are basically three types of margins in the derivatives
market.
These are the initial margin, maintenance margin, and variation
margin.
a) Initial margin
This is the initial cash that you must deposit into your account
before you start trading.
This is necessary to ensure that the parties honor their
obligation and provide a scope for losses in the business.
In simple words, it is like a down payment for the delivery of
the contract.
b) Maintenance margin
It is a cash balance that a trader must bring to maintain his
account as it can change due to price fluctuations.
The maintenance margin is a fixed portion of the initial margin
for a position.
If the margin balance in the account goes below such margin, the
trader is asked to deposit the required funds or to bring the
collateral back to the initial margin requirement.
This is known as a margin call.
c) Variation margin
As soon as the margin falls below the maintenance margin, you
need to deposit cash or collateral to get the account back to
the initial margin.
Point to remember.......
- A derivative is a financial contract that derives its value from one or more underlying assets.
- Derivatives can be forward, futures, options, and swaps.
- Most derivatives are used as a hedging tool or for speculating changes in the prices of an underlying asset
- Derivatives are highly leveraged instruments that increase their potential risk and rewards.
- There are basically three types of margins in derivatives trading, which are initial margin, maintenance margin, and variation margin.
If you have more information regarding the share market then visit the
following post.
.png)
