Derivatives / Derivative Securities

The term derivatives or derivative securities refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark.

A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC).

These contracts can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset.

These financial securities are commonly used to access certain markets and may be traded to hedge against risk.

Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation). Derivatives can move risk (and the accompanying rewards) from the risk-averse to the risk seekers.

A derivative is a financial contract which derives its value from one or more underlying assets.

Derivatives can be forward, future contract, options and swap.

Most derivatives are used as a hedging tool or to speculate changes in the prices of an underlying asset

Derivatives are highly leveraged instruments which increases their potential risk and rewards.

There are basically three types of margin in derivative trading which are Initial margin, Maintenance margin, and Variation margin. 

Participants in the Derivatives Market

The participants in the derivatives market can be broadly categorized into the following four groups:

1. Hedgers

Hedging is when a person invests in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements.

Derivatives are the most popular instruments in the sphere of hedging.

It is because derivatives are effective in offsetting risk with their respective underlying assets.

2. Speculators

Speculation is the most common market activity that participants of a financial market take part in.

It is a risky activity that investors engage in. It involves the purchase of any financial instrument or an asset that an investor speculates to become significantly valuable in the future.

Speculation is driven by the motive of potentially earning lucrative profits in the future.

Read: Investment vs Speculation | 7 key Difference

3. Arbitrageurs

Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of or profiting from the price volatility of the market.

Arbitrageurs make a profit from the price difference arising in an investment of a financial instrument such as bonds, stocks, derivatives, etc.

4. Margin traders

In the finance industry, the margin is the collateral deposited by an investor investing in a financial instrument to the counterparty to cover the credit risk associated with the investment.

Types of Derivative Contracts

Derivative contracts can be classified into the following four types:

1. Options

Options are financial derivative contracts that give the buyer the right, but not the obligation; to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period of time.

American options can be exercised at any time before the expiry of their option period. On the other hand, European options can only be exercised on their expiration date.

2. Futures

Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date.

The parties involved in a futures contract not only possess the right but also are under the obligation, to carry out the contract as agreed.

The contracts are standardized, meaning they are traded on the exchange market.

3. Forwards

Forwards contracts are similar to futures contracts in the sense that the holder of the contract possesses not only the right but is also under the obligation to carry out the contract as agreed.

However, forward contracts are over-the-counter products, which means they are not regulated and are not bound by specific trading rules and regulations.

Since such contracts are unstandardized, they are traded over the counter and not on the exchange market.

As the contracts are not bound by a regulatory body’s rules and regulations, they are customizable to suit the requirements of both parties involved.

4. Swaps

Swaps are derivative contracts that involve two holders, or parties to the contract, to exchange financial obligations. 

Interest rate swaps are the most common swaps contracts entered into by investors. Swaps are not traded on the exchange market.

They are traded over the counter, because of the need for swap contracts to be customizable to suit the needs and requirements of both parties involved.

Criticisms of the Derivatives Market

1. Risk

The derivatives market is often criticized and looked down on, owing to the high risk associated with trading in financial instruments.

2. Sensitivity and volatility of the market

Many investors and traders avoid the derivatives market because of its high volatility.

Most financial instruments are very sensitive to small changes such as a change in the expiration period, interest rates, etc., which makes the market highly volatile in nature.

3. Complexity

Owing to the high-risk nature and sensitivity of the derivatives market, it is often a very complex subject matter.

Because derivatives trading is so complex to understand, it is most often avoided by the general public, and they often employ brokers and trading agents in order to invest in financial instruments.

4. Legalized gambling

Owing to the nature of trading in financial markets, derivatives are often criticized for being a form of legalized gambling, as it is very similar to the nature of gambling activities.

Frequently Asked Questions