Derivatives are instruments whose value is derived from one or more underlying financial asset. The underlying instrument could be financial security, a securities index, or some combination of securities, indexes, and commodities. Derivatives are financial instruments that have no intrinsic value.
They hedge the risk of owning things that are subject to unexpected price fluctuations, for example, foreign currencies, barries of wheat, stocks, and government bonds.
Functions of Derivatives
The derivatives perform a number of functions which are as follows:
1. Help in Discovery of Price
Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.
The prices of derivatives coverage with the prices of the underlying at the expiration of the derivative contract.
Thus, derivatives help in the discovery of the future as well as current prices.
2. Helps to Transfer Risks
The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
3. Higher Trading Volumes
Derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market withness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
4. Control Market Activities
Speculative trades shift to a more controlled environment of the derivatives market.
In the absence of an organized derivatives market, speculators trade in the underlying cash markets.
Managing, monitoring, and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.
Acts as Catalyst
An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.
The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude.
They often energize others to create new businesses, new products, and new employment opportunities, the benefits of which are immense.
Types of Derivatives
The most popularly used derivatives contracts are as follows:
1. Options
An option represents the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price (the strike price). Options are two types:
- Call Option: It gives the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
- Put Option: It gives the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
2. Futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.
Futures contracts are special types of forwarding contracts in the sense that the former are standardized exchange-traded contracts.
Unlike forward contracts, the counterparty to a futures contract is the clearing corporation on the appropriate exchange.
Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. Parties to futures contracts may buy or write options on futures.
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3. Forwards
A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.
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Forward contracts are generally traded on OTC.
4. Swaps
Swaps are private agreements between two parties to exchange cash flows in the future according to a pre-arranged formula.
They can be regarded as a portfolio of forwarding contracts.
Swaps generally are traded OTC through swaps dealers, which generally consist of large financial institutions or other large brokerage houses.
There is a recent trend for swap dealers to mark to market the swap to reduce the risk of counterparty default.
5. Exotic/Sophisticated Derivatives
Exotic derivatives are specific types of financial assets. These are derivatives (assets whose value depends on another underlying asset) that do not have a standard pay off, as is the case for a regular call option.
It refers to any derivative security which is not European or American vanilla call or put on a single underlying security.
These options are more complex than options that trade on an exchange and generally trade over the counter.
For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the option is a put or call a certain point during the options life.
Because this type of option can change over the holding period, it is apparent that this type of option would not be found on a regular exchange, which is why it is classified as an exotic option.
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Other types of exotic options include:
- Barrier options,
- Asian options,
- Digital options, and
- Compound options.
Traders in Derivative Markets
Those who trade or participate in derivative/underlying security transaction may be broadly classified into three categories:
1. Hedgers
Hedgers are those traders who wish to eliminate price risk associated with the underlying security being traded.
The objective of these kinds of traders is to safeguard their existing positions by reducing the risk.
They are not in the derivatives market to make profits.
2. Speculators
While hedgers might be adept at managing the risks of exporting and producing petroleum products around the world, there are parties who are adept at managing and even making money out of such exogenous risks.
Using their own capital and that of clients, some individuals and organizations will accept such risks in the expectation of a return. But unlike investing in business along with its risks, speculators have no clear interest in the underlying activity itself.
For the possibility of a reward, they are willing to accept certain risks.
They are traders with a view and objective of making profits. These are people who take positions (either long or short positions) and assume risks to profits from fluctuations in prices.
They are willing to take risks and them et upon whether the markets would go up or come down.
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3. Arbitrageurs
The third player is known as arbitrageurs. From the French fr arbitrage or judge, these market participants look for mispricing and market mistakes, and by taking advantage of them; they disappear and never become too large.
If you have even purchased a product of a greengrocer only to discover the same products somewhat cheaper at the next grocer, you have an arbitrage situation.
Arbitrage is the process of the simultaneous purchase of securities or derivatives in one market at a lower price and sale thereof in another market at a relatively higher price.
Advantages of Derivatives
The advantages of derivatives are as follows:
1. Reflect Perception of Market Participants
Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.
The prices of derivatives converge with the prices of the underlying at the expiration of the derivatives contract.
Thus, derivatives help in the discovery of the future as well as current prices.
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2. Attract Entrepreneurially
An important incident benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.
The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude.
They often energize others to create new businesses, new products, and new employment opportunities, the benefits of which are immense.
3. Flexibility
Derivatives can be used with respect to commodity price, interest and exchange rates, and equity price.
They can be used in many ways.
4. Stable Economy
Derivatives have a stabilizing effect on the economy by reducing the number of businesses that go under due to volatile market forces.
5. Lower Transaction Costs
It translates into low transaction costs due to the high no. of participants that take part in the market.
Disadvantages of Derivatives
The disadvantages of derivatives are as follows:
1. Speculative and Gambling Motives
One of the most important arguments against derivatives is that they promote speculative activities in the market.
It is witnessed from the financial markets throughout the world that the trading volume in derivatives has increased in multiples of the value of the underlying assets and hardly one to two percent derivatives are settled by the actual delivery of the underlying assets.
2. Increase in Risk
The derivatives are supposed to be an efficient tool for risk management in the market.
In fact, this is also a one-sided argument. It has been observed that the derivatives market- especially OTC markets, as particularly customized, privately managed, and negotiated and thus, they are highly risky.
3. Instability of the Financial System
It is argued that derivatives have increased risk not only for their users but also for the whole financial system.
The fear of micro and macro-financial crisis has caused to the unchecked growth of derivatives which has turned many market players into big losers.
The malpractices, desperate behavior, and fraud by the users of derivatives have threatened the stability of the financial markets and the financial system.
4. Price Instability
Some experts argue in favor of the derivatives that their major contribution is towards price stability and price discovery in the market whereas some others have doubts about this.
Rather they argue that derivatives have caused wild fluctuations in asset prices and moreover, they have widened the range of such fluctuations in the prices.
The derivatives may be helpful in price stabilization only if there is a property organized, competitive, and well-regulated market.
5. Increased Regulatory Burden
Derivatives create instability in the financial system as a result, there will be more burdens on the government or regulatory authorities to control the activities of the financial derivatives.
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