What is Financial Derivative ?
Derivative is a contract or a product whose value is derived from value of some other asset known as underlying asset. Or we can say, Derivative is a financial instrument whose value is derived from the value of an underlying asset. The underlying asset can be equity shares or index, precious metals, commodities, currencies, interest rates etc. A derivative instrument does not have any independent value. Its value is always dependent on the underlying assets. Derivatives can be used either to minimise risk (hedging) or assume risk with the expectation of some positive pay-off or reward (speculation).
These include:
- Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc.
- Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas etc.
- Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses etc, and
- Financial assets such as Shares, Bonds and Foreign Exchange.
Example:
Suppose you predict that Nifty 50 will go uptrend or bullish in the upcoming days then you decided to purchase derivative(contract) in terms of future & options at the lower value to get higher returns on a specific maturity date.
Here, Nifty 50 is the underlying asset and Nifty future is the derivative instrument. Same goes to, Gold(underlying) & Gold Future(derivative).
History & Evolution
Factors influencing the growth of derivative market globally:
- Increased fluctuations in underlying asset prices in financial markets.
- Integration of financial markets globally.
- Use of latest technology in communications has helped in reduction of transaction costs.
- Enhanced understanding of market participants on sophisticated risk management tools to manage risk.
- Frequent innovations in derivatives market and newer applications of products.
Major segments on which Derivatives are traded:
- Exchange Traded Markets - Exchange-traded Market is platform where the contracts are standardised, traded on organised exchanges with prices determined by the interaction of buyers and sellers through anonymous auction platform. A clearing corporation, guarantees contract performance (settlement of transactions).
- Over the Counter (OTC markets) - Over the Counter (OTC) derivative contracts are signed between the two parties without going through the platform of a stock exchange or any other intermediary. OTC is the term used to refer stocks that trade through a separate dealer. These are well known as unlisted stocks where the securities are traded by broker-dealers through over the counter negotiations.
Some common types of Derivatives
Forward
A forward is a contractual agreement between two parties to
buy/sell an underlying asset at a future date for a particular price that is
pre‐decided on the date of contract. Both the contracting parties are committed
and are obliged to honour the transaction irrespective of price of the
underlying asset at the time of delivery. Since forwards are negotiated between
two parties, the terms and conditions of contracts are customised. Forwards
contracts are negotiated bilaterally between two parties in Over the counter
(OTC) markets and are not traded on the Stock Exchange.
Futures
A futures contract is similar to a forward, except that the
deal is made through an organised and regulated exchange rather than being
negotiated directly between two parties. Indeed, we may say futures are
exchange traded forward contracts.
Options
An Option is a contract that gives the right, but not an
obligation, to buy or sell the underlying on or before a stated date and at a
stated price. While buyer of option pays the premium and buys the right so
write off the contract at any time whereas the writer/seller of option receives
the premium with an obligation to sell/ buy the underlying asset, if the buyer
exercises his right.
There are two types of Options, Call Options and Put Options
- A call option gives, the holder, the right to buy a specified quantity of the underlying asset at the strike price on a predetermined date.
- A put option, on the other hand, gives, the holder, the right to buy a specified quantity of the underlying asset at the strike price on a predetermined date.
Swaps
A swap is an agreement made between two parties to exchange
cash flows in the future according to a prearranged formula. Swaps are, broadly
speaking, series of forward contracts. Swaps help market participants manage
risk associated with volatile interest rates, currency exchange rates and
commodity prices.
Market Participants
Hedgers
They face risk associated with the prices of underlying assets and use derivatives to reduce their risk. Corporations, investing institutions and banks all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices.
Speculators/Traders
They try to predict the future movements in prices of underlying assets and based on the view, take positions in derivative contracts. Derivatives are preferred over underlying asset for trading purpose, as they offer leverage, are less expensive (cost of transaction is generally lower than that of the underlying) and are faster to execute in size (high volumes market).
Arbitrageurs
Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to these transactions, thus closing the price gap at different locations.
Advantages
Since the value of the derivatives is linked to the value of
the underlying asset, the contracts are primarily used for hedging risks. For
example, an investor may purchase a derivative contract whose value moves in
the opposite direction to the value of an asset the investor owns. In this way,
profits in the derivative contract may offset losses in the underlying asset. Derivatives
are frequently used to determine the price of the underlying asset. For
example, the spot prices of the futures can serve as an approximation of a
commodity price. It is considered that derivatives increase the efficiency of
financial markets. By using derivative contracts, one can replicate the payoff
of the assets. Therefore, the prices of the underlying asset and the associated
derivative tend to be in equilibrium to avoid arbitrage opportunities. Derivatives
can help organisations get access to otherwise unavailable assets or markets.
By employing interest rate swaps, a company may obtain a more favourable
interest rate relative to interest rates available from direct borrowing.
Disadvantage
The high volatility of derivatives exposes them to
potentially huge losses. The sophisticated design of the contracts makes the valuation
extremely complicated or even impossible. Thus, they bear a high inherent risk.
Derivatives are widely regarded as a tool of speculation. Due to the extremely
risky nature of derivatives and their unpredictable behaviour, unreasonable
speculation may lead to huge losses. Although derivatives traded on the
exchanges generally go through a thorough due diligence process, some of the
contracts traded over-the-counter do not include a benchmark for due diligence.
Thus, there is a possibility of counter-party default.
Financial Derivatives - Concepts, Types, Examples and Risk
Financial Derivatives - Future Terminologies with example 2021
Financial Derivative - Forward Contracts with PAYOFF Matrix 2021
Financial Derivatives - Future Contract with P&L and Payoff Matrix 2021
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