What is Derivative Market?
A derivative is a contract that is usually between two parties whose value is based on an agreed underlying financial asset. This can also be a set of assets. The most common underlying instruments would include bonds, currencies, commodities, market indexes, interest rates, and stocks.
However, the market can be divided into exchange trades and over-the-counter trades. The exchange and over-the-counter trades are very different in their legal nature and trading ways. However, numerous market investors are active in both. Of the two, over-the-counter derivatives make up the largest portion and remain unregulated.
The participants in the derivatives market are of four types, based on their motives, namely:
- Margin traders
- Hedgers are the primary participants in the sphere of off-setting risk with derivatives.
- A hedger is any individual or can also be a firm that purchases or sells the actual physical commodity in the financial market to reduce the risk of price volatility in the exchange market. Many hedgers are producers, wholesalers, retailers, manufacturers, who are affected by changes in commodity prices, exchange rates, and interest rates.
- They are so keen to exclude themselves from the uncertainty that is associated with price movements. Hedgers are also known as the least risk lover in the derivatives market. Their main aim is always to reduce the impact of losses if any.
- Speculators are individuals or firms who speculate (guess) that the price of assets will go up or down.
- Speculators trade derivatives based on their speculation. Speculation is the most common market activity that participants of a financial market take part in.
- It is a risk that investors engage in by speculating the value of assets. Venture capitalists, private equity firms, individual traders, portfolio managers, market makers are all speculators accepting risk to make profits.
- The higher the risk, the greater is the chance of high returns and profits by purchasing at cheap prices and selling at much higher prices.
- Such differences in the risk profile help in distinguishing hedgers from speculators. Speculators are the real traders.
- The information that they hold may not be easily available elsewhere. They also aid others in analyzing the derivatives markets.
- Arbitrageurs are individuals who earn profits by taking advantage of price volatility in financial markets.
- Arbitrageurs make profits when an asset is priced differently between multiple markets at the same time, such as bonds, stocks, derivatives, etc.
- Arbitrage trade is a low-risk trade because of the simultaneous purchase of assets in one market that can be corresponded with a sale in another market.
- It exploits short-lived variations in the price of identical or similar financial instruments in different markets or different forms.
- These are types of traders who participate in the market to obtain risk-free profits. For example, one can always sell a stock on the national stock exchange and buy simultaneously back on the Bombay stock exchange platform.
- These kinds of traders always have an eye on various markets and immediately grab any opportunity available wherein they can buy from one market and sell in the other. In such a way, they can trade and make a riskless profit.
- Margin traders:
- In finance, the margin is the collateral that an investor must deposit with their broker or the exchange through the counterparty to cover the credit risk associated with the investment.
- An investor can create credit risk if they borrow from the broker to buy assets, borrow derivatives to sell them, or enter a derivative contract. Hence speculators use a payment mechanism, which is unique to derivative markets, called ‘Margin Trading’.
- Buying on margin occurs when an investor buys an asset by depositing a fraction of the value with the broker and borrowing an amount equal to the remaining value.
- The investor uses the securities in their brokerage account as collateral, giving a high leverage factor to buy three to five times more than the actual capital investment.
- Although, the borrowing limit from a broker is fixed too. The conclusion of trade between investor and broker is called ‘settlement’.
- The investor needs to either pay outstanding dues or conduct an opposing trade (buy or sell) that would nullify the amount payable to the broker.
There are also different types of derivative contracts, and they are as follows:
- Options are a type of financial derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price, that too during a specific period. The price here is referred to as the strike price.
- Futures are that type of contract which are standardized contracts that allow the holders of the contract to buy or sell the underlying asset at an agreed price and on a specific date.
- The parties that are involved in such kinds of contracts not only have the right but also an obligation to carry out the contract as agreed.
- Forwards are that type of contract which are like the futures, but the only difference here is that these contacts are not standardized and are also not regulated by specific trading rules or regulations.
- Swaps are that type of derivative contract where the parties involved are for the purpose of exchanging financial obligations.
- These contracts are not traded in the exchange market but are traded over the counter.
- These contracts are customizable to meet the needs and requirements of both parties involved.
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