What are Derivatives?

Last Updated on December 28, 2021

Derivatives is a popular term in the financial world. People who deal in finance and capital markets are generally familiar with derivatives. It is used as a financial device or financial instrument to hedge funds, get an arbitrage advantage, as an investment avenue to park surplus funds and obtain gains through derivatives trading or most likely to generate wealth.

Definition of Derivatives

Derivatives are financial contracts and its value is depend on an underlying asset or group of assets which can be anything from commodities, stocks, currencies or real-estate. The value of those underlying assets keep change or fluctuate according to the market conditions.

The basic principle behind entering into a derivative contract is to earn profit by speculating on the value of the underlying assets in the future.

Forward Contract

Example: Let understand a commodity derivative; A sugar mill manager wants to buy 100 tonnes of sugarcane 3 months later, but he is expecting that the price of the sugarcane will rise in the future.

Similarly, a farmer who grows sugarcane wants to sell his crops after 3 months, but he is speculating that the price of the sugarcane will fall in the future.

Suppose, the price of the sugarcane at present is Rupees 5,000 per tonne.

The sugar mill manager and the farmer to protect the value of the crop against uncertainty will enter into a contract. The manager agrees to buy the sugarcane crop and the farmer agrees to sell his crop at Rupees 5,000 per ton after 3 months. Thus, a forward contract is formed.

If after 3 months any of the conditions arises i.e. a rise or fall in sugarcane price. Both parties have the right to exercise the contract or to terminate it. In case, if they exercise it one of the parties to the contract is on the winning side and another is on the losing side.

The underlying asset in the above example is the sugarcane crop. Thus, a derivate contract is used to hedge the future price of the sugarcane crop.

Types of Derivatives

There are 4 common derivatives that are traded in the capital markets.

1. Forward

These are simple contracts made between parties to buy or sell the underlying assets at a specified date and an agreed price in the future. These contracts are tailor-made according to the needs of the interested parties.

The forward contract is traded over-the-counter (OTC) and settlement is done on the maturity date. No collateral is required to enter into a forward contract.

As these are private contracts there is no regulatory involved and the chance of default is relatively high.

2. Futures

These are standardized contracts that allow the contract holder to buy or sell the underlying assets at an agreed price at the specified maturity date. The parties to the futures contracts are under the obligation to execute the contract.

These contracts are traded on the stock exchanges. The value of the futures contracts is mark-to-market and settlement is done every day. The party is required to maintain an initial margin in the trading account before entering into the futures contract.

The maturity date is pre-determined as it is regulated by the stock exchange. Futures are highly traded derivatives in the stock market.

3. Options

These are also standard contracts that give the buyer of the option contract to either buy (long) or sell (short) the underlying assets at the specified price at a certain period of time.

The seller of the option contract is known as the option writer. The specified price on which option contract is exercise is known as the strike price. The buyer of the option holds only the rights and not the obligation to fulfill the contract.

The buyer has to pay an amount of premium to purchase the option contract. He/she can either buy or sell the rights they hold of the underlying assets of the contract.

Options are traded on stock exchanges and there are various options strategies use by the traders to create gains out of it.

Option are of two types:

  1. Call option- Right to buy an underlying asset of the contract at the strike price.
  2. Put option- Right to sell an underlying asset of the contract at the strike price.

4. Swaps

Around 1980s, the first derivatives Swap contract was developed. It is another forward based derivative contract which obligates two counterparties to exchange a series of cash-flow at specified settlement dates in the future.

Swap contracts are entered into through private negotiations to meet each party’s specific objectives. These are also tailor-made contracts and are traded over-the-counter (OTC).

Swaps are of two types:

  1. Interest rate swaps
  2. Currency swaps

Players of the Derivative Market

1. Hedgers

They use derivatives as a tool to manage uncertainty and to reduce financial risks. They take opposite positions in derivative contracts to protect their financial position against market movements. Hedgers’ have the prospect that price of the underlying assets might move against the market mood, or of their prediction.

Example: A bread maker wants to purchase after 6 months from today, 1000 Kilograms of wheat at current market price which is Rupees 25 per Kilogram.

He has a thought that the price of wheat will rise in the future. To hedge its position, the bread maker will enter into a 6 months Forward contract with a wheat farmer to purchase from him 1000 Kilograms of wheat at the price of Rupees 25 per Kilogram after 6 months from today.

2. Speculators

They use derivatives to wager on it. Derivatives are used by the speculators not to reduce financial risk but to potentially profit from it. They speculate/predict or can say taking a view to the future that the price of the underlying assets will rise or fall in the future. Accordingly, they take buy/sell positions in derivative contracts to earn profit from it.

Example: Mr. T has a view that the stock price of the HDFC bank will rise in 6 months from today. So, he decides to buy a Call Option of HDFC bank of 6 months maturity at today’s strike price.

After 6 months, if the HDFC bank’s stock price rises he will exercise the Call Option otherwise he will opt not to exercise the Call Option by paying the premium amount.

3. Arbitrageurs

They are risk-averse. The arbitrageurs search for the pricing mistakes or inefficiencies in the derivatives markets and attempt to benefit from it by taking no risk if they do it right.

Example: In a stock market, if at a point of time exactly the same Option contract is trading in one market for a price of Rupees 100 and in another stock market for the price of Rupees 105.

An arbitrageur will simultaneously buy at Rupees 100 and sell at Rupees 105, and will make a profit with virtually no risk.

4. Market Makers

They are the merchants of the derivative contracts. They buy the derivatives at one price and sell at the higher price. Thus, pocketing the difference as their profit or bid-ask spread.

What is Hedging?

It is a strategy to manage the risk that uses derivatives to protect the financial loss by taking an opposite position in the capital market.

Bid-ask Spread?

A bid is a price at which the trader wants to purchase the derivative contract and Ask is the price that the market-maker offers at which he wants to sell the derivative contract.
The difference between Bid and Ask is its spread.

Intrinsic Value?

It is the difference between the Strike price (S) of the stock and the current price (K) of the stock or zero, whichever is greater.
Int.Val.=Max (S-K, 0)

What are the 4 derivatives?

Derivatives are of 4 types i.e. Forward, Futures, Options (Call &Put) and Swaps.

What is derivatives in simple words?

Derivatives are financial contracts and its value is depend on an underlying asset or group of assets. The value of those underlying assets keep change or fluctuate according to the market conditions.

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