Classification of derivatives
Derivatives can be broadly divided into two distinct groups:
Over the Counter (OTC): The OTC derivative market is the largest market for derivatives. Here, the derivatives are traded privately without an exchange. Products such as swaps, exotic options, and forward rate agreements are traded between highly sophisticated financial entities such as hedge funds and banks in private.
Exchange-traded derivative contracts (ETD): ETDs are derivative instruments that are traded in a derivatives exchange. This exchange acts as an intermediary in all related transactions. As a guarantee, an initial margin is submitted by both the buyer and the seller of the contract.
Functions of derivatives
Risk management: The prices of derivatives are related to their underlying assets, as mentioned before. They can thus be used to increase or decrease the risk of owning the asset. For example, you can reduce your risk by buying a spot item and selling a futures contract or call option. This is how it works. If there is a fall in the spot price, the corresponding futures and options contract will also fall. You can repurchase the contract at a lower price, which will result in a gain. This can partially offset the loss on the spot item. The ease of speculation in the derivatives market makes it easier for an investor seeking to protect a position or an anticipated position in the spot market.
Price discovery: Derivative market serves as an important source of information about prices. Prices of derivative instruments such as futures and forwards can be used to determine what the market expects future spot prices to be. In most cases, the information is accurate and reliable. Thus, the futures and forwards markets are especially helpful in price discovery mechanism.
Operational advantages: Derivative markets have greater liquidity than the spot markets. The transactions costs therefore, are lower. This means commissions and other costs for traders is lower in derivatives markets. Further, unlike securities markets that discourage shorting, selling short is much easier in derivatives.
Therefore, by virtue of risk management, short selling, price discovery, and improved liquidity, derivatives make the markets more efficient.
Types of derivatives
Futures: These are arrangements to buy or sell a fixed quantity of a particular security or currency for a fixed price and date in the future.
Option: The owner of an option does not have the obligation but the option to buy or sell a particular security, currency on or before a predetermined date.
Swap: A derivative is a financial instrument that derives its value from an underlying asset. The underlying asset can be equity, currency, commodities, or interest rate. Thus, a change in the underlying asset leads to an equivalent change in the derivative. Derivative markets are investment markets where derivative trading takes place.
Applications of derivatives
Now that we have learnt the functions and advantages and types of derivatives, here is a closer look on how they are used:
Hedgers: Hedging is a market mechanism by which an investor protects erosion of asset value due to an adverse price movement. Hedgers therefore, use derivatives especially during market volatility. This is to streamline future cash flow and ensure that there is minimal loss of asset value in the future.
So, for example, an investor has a stock portfolio of Rs5 lakh. He may not be keen on liquidating any positions ahead of key macroeconomic events such as budget or monetary policy announcements. He may, therefore, choose to protect his portfolio by shorting index futures. He can also choose to pay a fixed cost in the form of a premium and purchase a put option instead.
Speculators: Speculators, in a way are the exact opposite of hedgers. Rather than protecting their portfolio, they look at making higher gains in a shorter time frame. A speculator may therefore want to take advantage of price movements during times of volatility and make a large profit in the process.
For example, if a speculator has the idea that the price of company A may fall in a few days due to policy announcements, he would choose to short sell the shares of company A ahead of the event. If the fall takes place as per his expectations, he has the opportunity to make a good profit. On the other hand, if the stock price of A rises against his expectations, he will suffer a hefty loss.
Arbitrageurs: The main objective of an arbitrageur is to exploit the price differentials in different markets. He will therefore buy an asset at a cheaper rate in one market and sell it at a higher rate in another. This results in a low risk profit opportunity. However, such windows of opportunities are very brief in the derivatives market and may turn out to be a risky trade.
For example, say, the stock of company X is trading at Rs50 in the spot market and simultaneously quoting at Rs55 in the future market. An arbitrageur would buy 100 shares of company X at Rs50 in the cash market. Simultaneously, he would sell 100 shares at Rs55 in the futures market. As a result, he will make a profit of Rs5 per share.
To sum it up, therefore, the functions of derivatives are as follows:
- They enable price discovery, improve liquidity of the underlying asset they represent, and finally serve as effective instruments for hedging.
- Derivatives are financial instruments that have characteristics of high leverage and are complex in their pricing and trading.