What are Derivatives and How it Works?

Derivatives are a form of special financial instrument where the value of these instruments is derived from an underlying asset or an index. As the name goes, derivatives are linked to some form of financial instrument, indicator, or commodity. Some commonly used assets include stocks, bonds, commodities, currencies, and market indices. Initially, these underlying assets are created using any individual security or a combination of securities. As the value of these securities changes, the value of the derivatives also keeps changing. Derivatives are those complex instruments used in trading risk in the financial markets by either hedging, speculating, or arbitraging. Derivatives form the basic concept under consideration in financial engineering. The primary purpose of derivative contracts is to generate profit by speculating the future value of the underlying asset.

Geeky Takeaways:

• Derivatives are financial contracts where the value is determined based on the underlying stocks, bonds, commodities, or certain market indices. In simple words, predicting and agreeing to a future value of an underlying asset.
• These financial contracts are used by hedgers, speculators, arbitrageurs, and margin traders for risk management, hedging, speculation, and arbitrage among different markets.
• Derivatives are traded in two platforms either via over-the-counter (OTC) trading or via a standardized exchange.
• These contracts can take either simple or complicated forms of options, futures, forwards, swaps, or warrants.

How are Derivatives Used?

Derivatives are used commonly in two ways, either via hedging (managing risks) or by speculating (presuming the risk with the expectation of equal returns). The value of the underlying assets varies according to market conditions. The main purpose for engaging in derivative contracts is to generate revenue through predictions of the underlying asset's potential future value.

1. Risk Management: The financial risks are managed using the derivatives. To safeguard from the risk of declining prices, a farmer, for instance, might use a futures contract to seal in a price for crops (say rice) before they are harvested. In this way, the farmer protects itself from the market fluctuations.

2. Speculation: With the help of derivatives, investors speculate to earn profit from the price movements in the underlying assets without actually owning them. Suppose, purchasing futures or options contracts to capitalize on anticipated market changes.

3. Hedging: Derivatives are used by investors or businesses to hedge against adverse price fluctuations. For instance, an MNC that deals in diverse currencies may use currency derivatives to minimize the impact of exchange rate fluctuations on its profits.

Different Types of Derivative Contracts

The different types of derivative contracts are as follows:

1. Options: One of the common forms of derivatives is the Options contract. These are the financial contracts where the buyer or seller has the right to either buy or sell an underlying asset but not the obligation to do so. Options and futures are quite similar except for the obligation factor. Here, the two parties (buyer or holder and seller or writer) deal a contract to trade an underlying asset at a predetermined price for a future date. The parties are under no obligation to exercise the contract, i.e., they can either exercise their right or else leave the contract before the expiry date. Two types of options are available: Call and Put option.

2. Futures: Futures derivative contracts are standardized agreements to trade an underlying asset at a predetermined price on a specified future date. Here, parties exercise their contract with the help of a third party (exchanges). Some common underlying assets include commodities, financial instruments, and stock indices.

3. Forwards: Forward derivative contracts are similar to the futures contracts. The only difference is that forwards are customizable contracts between two parties to trade an underlying asset at an agreed-upon future date and price. They are exercised over-the-counter (OTC) and are more tailored to the needs of both the parties involved.

4. Swaps: Another form of derivative is the swap contract. It involves the exchange of cash flows or any other financial instruments among two parties (buyer or seller). Some of the common types of swaps include interest rate swaps (fixed-rate and floating-rate interest are exchanged), currency swaps (cash flows in different currencies are exchanged), and commodity swaps (cash flows based on commodity prices are exchanged).

5. Warrants: These are different forms of derivative options that are issued by an enterprise. Here, the holder (buyer) is given the right to buy the shares of the company at a predetermined price for a specified period. They are often used as incentives or sweeteners in securities offerings.

Main Benefits of Derivatives

Derivatives have several benefits but the main benefits are as follows:

1. Risk Management: Till now, we have come to know that derivatives are a powerful tool to manage and mitigate financial risk. They allow investors to hedge against volatile price fluctuations in assets, such as commodities, currencies, stocks, interest rates, or indices. This risk management aspect of derivatives is essential for stabilizing cash flows and protecting portfolios from uncertain market fluctuations.

2. Market efficiency and Price discovery: In a derivative market, the individuals involved in these agreements, predict the market prices and agree to future asset prices. This factor contributes to the price discovery aspect of derivatives. With the different derivatives contracts, participants express their views on where the prices would head (either bull or bear). This pricing factor benefits investors, businesses, and policymakers, making the market more efficient. New and enhanced information regarding the asset prices, makes the markets more responsive towards dynamic economic conditions.

3. Enhanced Portfolio Management and Speculation: Diversification and enhancement of portfolio returns can happen using the derivatives. As these are an advanced form of financial instruments, investors can use sophisticated investment strategies to achieve a more balanced and diversified portfolio. Further, certain speculated profits can be generated by the anticipated market movements without the requirement for actual investment, although certain risk is associated with it.

Risks of Derivatives

There are certain risks associated with derivative contracts:

1. Market Risk: Derivatives are exposed to movements in the underlying asset prices. If the market moves against the predicted direction, investors can incur significant losses. This risk is inherent due to the volatile nature of markets.

2. Counterparty Risk: As derivatives involve two parties (buyer and seller), there is a risk that one party might default on its obligations. Counterparty risk increases the potential for financial loss if the other party fails to fulfill the terms of the derivative agreement. This mostly happens in case of the forward contracts where no third party is involved in monitoring the trading.

3. Liquidity Risk: Certain derivatives lack liquidity which makes it difficult to trade them quickly at a fair price. Illiquid markets can result in wider bid-ask spreads and may lead to difficulties in executing trades.

4. Operational Risk: In the derivatives contracts, sometimes certain errors might occur in the processing or exercising phase, technological failures, or other operational issues that can lead to financial losses. Operational risk is associated with the infrastructure and processes supporting the transactions.

5. Basis Risk: The basis risk occurs when the relationship between the derivative and its underlying asset diverges unexpectedly. Basis risk can occur due to differences in interest rates, maturities, or other factors, leading to unexpected financial outcomes.

6. Interconnection Risk: There is a risk association in the relationship or interconnection between the different derivatives contracts and the dealers (e.g., banks). As per analysts, if only one party is involved (a major bank) that deals with the derivatives, might cause a snowball effect or chain reaction that would disturb the stability of the overall financial market.

Trading in the Derivatives Market

The derivative market is exposed to certain risks and volatile market movements. Hence, it is prudent to understand the nitty-gritty of trading in the derivative market so as to earn maximum with minimum risk. The following steps help in trading efficiently in the volatile market.

Step 1: Prior to trading the different types of derivatives, one must open an online trading or demat account. In the case of hiring brokers for trading derivatives, one can take orders over the phone or online mode.

Step 2: Before beginning the trading, a premium amount needs to be paid and it cannot be withdrawn until the contract is completed and the trading is closed. In case, your premium amount goes below the minimum permissible amount while trading, you will be given a notification to rebalance it.

Step 3: You should be aware of the underlying asset and all the information should be known. Further, a budget needs to be prepared and it should be sufficient enough to fulfill the financial requirements of the premium for trading, cash in hand, and contract prices.

Step 4: Until the trading is closed, you should keep your investments in the contract.