Derivatives: Meaning, types of derivatives and participants

[ecis2016.org] Derivatives are contracts between two or more parties, whose values are based on an agreed-upon underlying financial asset or set of assets.

Derivatives are contracts between two or more parties whose values are based on an agreed-upon underlying financial asset (such as security) or set of assets (such as an index). Among the most common underlying instruments are bonds, commodities, currencies, interest rates, and market indexes.

You are reading: Derivatives: Meaning, types of derivatives and participants

What does derivatives mean?

Financial derivatives are contracts, whose value depends on an underlying asset, group of assets, or benchmark. Derivatives are contracts between two or more parties traded on an exchange or over-the-counter (OTC). Trades can be conducted with these contracts on a variety of assets, each carrying its own risk. Derivatives are priced according to changes in the underlying asset. In addition to being used to access certain markets, these financial securities may be traded to hedge against risk.

Derivatives: Types

Derivative contracts can be categorised into the following four types:

• Options

Financial derivatives are contracts that give the buyer the right to buy or sell an underlying asset at a certain price (called the strike price) at a specific time. Option holders in the United States are entitled to exercise their options at any time during their option period. European options, on the other hand, can only be exercised after the expiration date.

• Futures

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In a futures contract, the contract holder agrees to buy or sell the underlying asset at a fixed price on a specific date in the future. In a futures contract, the parties have the right and the obligation to carry out the terms of the contract. They are standardised ie., traded on exchanges.

• Forwards

The holder of a forward contract is similar to a futures contract in the sense that one is entitled and obligated to perform the contract as agreed. A forwards contract is an over-the-counter product, which means it is not regulated and governed by specific trading rules and regulations.

• Swaps

Exchange contracts involve two parties exchanging financial obligations. They are derivative contracts. Investors typically enter into interest rate swaps as their most common swap contract. Exchange-traded swaps are not available. Because swaps contracts must be customisable to meet both parties’ needs and requirements, they are traded over the counter.

Derivatives: Market participants

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

• Hedgers

Hedging involves investing in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminating the risk of future price movements. Hedging is most commonly done through derivatives. Due to their ability to off-set risk with their respective underlying assets, derivatives are effective in this regard.

• Speculators

Investments involving speculation are risky. An investor speculates that a financial instrument or an asset will become significantly valuable in the future by purchasing it. The motive behind speculation is the potential for lucrative profits in the future.

• Arbitrageurs

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Arbitrage takes advantage of profits from the price volatility of the market. An arbitrageur profits from the price difference arising from the investment of a financial instrument, such as bonds, stocks, derivatives, etc.

• 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.

What are the reasons investors enter into derivative contracts?

• Safeguard against price fluctuations

 An asset’s price fluctuation may increase your risk of losing money. If the price of the stocks you own drops, you can use derivatives to protect yourself. In addition, you may buy products to protect against a price rise if you are planning to buy shares.

• Benefit of arbitrage

Arbitrage trading involves buying a commodity or security at a low price in one market and selling it at a higher price in another market. In this way, you benefit from the differences in prices between the two markets.

• Transfers risk

Derivatives are sometimes used to transfer risk, or for speculation and to make money. With derivatives, you can profit from price fluctuations without actually having to sell the underlying shares.

Derivatives: How to trade?

• Trading on derivatives markets requires understanding how they work. A derivatives strategy is entirely different from one that is applicable to the stock market.
• You need to deposit a margin amount before you can begin trading in the derivative market. Once the trade is settled, the margin amount cannot be withdrawn. Additionally, you must replenish the amount when it falls below the minimum level.
• Trading derivatives should be permitted on an active trading account. You can place orders online or by phone if you are using the services of a broker.
• When selecting stocks, you need to consider factors such as cash on hand, margin requirements, the contract price, and the price of the underlying shares. Ensure that everything is within your budget.
• To settle the trade, you can choose to stay invested until the expiration. If this is the case, either pay the entire outstanding amount or enter into an opposing trade.

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