- Introduction:
- Why derivatives are important:
- Types of derivatives, the most common types of derivatives are:
- Futures contracts:
- Options contracts:
- Swaps:
- Advantages of the derivatives market:
- Disadvantages of the derivatives market:
- Conclusion
Introduction:
Derivatives market, as the term suggests, it is a market that is derived from an underlying market, which includes primarily options and futures, meaning that as there is an actual market, like stock, bonds, currencies, and commodities, the price of these instruments (options and futures) is derived from these actual markets.
The derivatives market is divided into two main parts: exchange-traded derivatives and over-the-counter (OTC) derivatives. Exchange-traded derivatives are standardized contracts that are traded on exchanges, such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE). Over-the-counter (OTC) securities are financial assets, like stocks or bonds, which are not listed on any major organized exchange, like the New York Stock Exchange (NYSE) or NASDAQ, but are being traded on a centralized exchange called as Over-the-counter, these securities are directly traded between parties though a network of brokers-dealers.
Why derivatives are important:
The derivatives market is a very large and complex market, with a global notional value of over $1 quadrillion. It is used by a wide range of participants, including hedgers, speculators, and arbitrageurs. Hedgers use derivatives to manage their exposure to the underlying asset. For example, a farmer might buy a futures contract on corn to lock in a price for their crop before it is harvested, or someone holding a large quantity of stock in a particular company may buy put options to hedge, if he is expecting a short term slowdown.
Speculators and traders, use derivatives to bet on the future price movements of the underlying asset. For example, a speculator might buy a call option on a stock if they believe that the stock price will go up or a put when they believe that the price may fall.
Please refer to my article, “Options Market”, to get a better idea of call and put options.
Options Market
Also, arbitrageurs use derivatives to profit from price differences in different markets. For example, an arbitrageur might buy a futures contract on wheat in one market and sell a futures contract on wheat in another market if the wheat price is higher in the first market or vice versa. Also, if there is a price difference in price of stock in different exchanges one can take advantage of this with advent of technology.
Types of derivatives, the most common types of derivatives are:
Futures contracts:
A futures contract is an agreement to buy or sell a specific asset at a predetermined price on a specific date in the future, they are created by exchange and traded in lot of a particular stock, commodity, currency etc.
Options contracts:
An options contract gives the buyer the right, but not the obligation, to buy or sell a specific asset at a predetermined price on or before a specific date in the future.
Swaps:
A swap is a contract between two parties to exchange cash flows based on an underlying asset or benchmark.
Advantages of the derivatives market:
The derivatives market offers a number of advantages, including:
- Risk Management:
Derivatives can be used to manage risk exposure to the underlying asset. For example, a company that uses a commodity in its production process can use derivatives to hedge against price fluctuations in that commodity.
- Price Discovery:
The derivatives market helps discover prices for underlying assets. This is because traders in the derivatives market are constantly buying and selling contracts based on their expectations of the future price of the underlying asset.
- Capital Efficiency:
Derivatives can be used to gain exposure to an underlying asset without having to invest the full value of the asset. This is because derivatives are leveraged instruments, meaning that traders can control a large position with a relatively small investment.
Disadvantages of the derivatives market:
The derivatives market also has a number of disadvantages, including:
- Complexity:
Derivatives can be complex instruments, and it is important to understand how they work before trading them.
- Risk:
Derivatives are leveraged instruments, which means that they can amplify both gains and losses.
Systemic risk: If a large number of traders lose money on their derivatives positions, it could lead to a financial crisis.
Conclusion
Overall, the derivatives market is a complex and risky market, but it also offers a number of advantages. It is important to understand how derivatives work and the risks involved before trading them.
