Derivatives are contracts that derive their value from the underlying asset.

These
are widely used to speculate and make money. Some use them as risk transfer
vehicle as well.

Imagine that the market price of an equity share may go up or down. You may
suffer a loss owing to a fall in the stock value. In this situation, you may enter a
derivative contract either to make gains by placing an accurate bet. Or simply
cushion yourself from the losses in the spot market where the stock is being traded.

What is the Derivatives Market?

The derivatives market refers to the financial market for financial instruments such
as futures contracts or options that are based on the values of their underlying
assets.

• There are four kinds of participants in a derivatives market: hedgers,

speculators, arbitrageurs, and margin traders.
• There are four major types of derivative contracts: options, futures,
forwards, and swaps.
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.
These are risk-averse traders in stock markets. They aim at derivative markets to
secure their investment portfolio against the market risk and price movements.
They do this by assuming an opposite position in the derivatives market. In this
manner, they transfer the risk of loss to those others who are ready to take it. In
return for the hedging available, they need to pay a premium to the risk-taker.
Imagine that you hold 100 shares of XYZ company which are currently priced at
Rs. 120. Your aim is to sell these shares after three months. However, you don’t
want to make losses due to a fall in market price. At the same time, you don’t want
to lose an opportunity to earn profits by selling them at a higher price in future. In
this situation, you can buy a put option by paying a nominal premium that will take
care of both the above requirements.

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. These are risk-takers of the
derivative market. They want to embrace risk in order to earn profits. They have a
completely opposite point of view as compared to the hedgers. This difference of
opinion helps them to make huge profits if the bets turn correct. In the above
example, you bought a put option to secure yourself from a fall in stock prices.
Your counterparty i.e. the speculator will bet that the stock price won’t fall. If the
stock prices don’t fall, then you won’t exercise your put option. Hence, the
speculator keeps the premium and makes a profit.

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.
Arbitrage trading involves buying a commodity or security at a low price in one
market and selling it at a high price in the other market. In this way, you are
benefited by the differences in prices of the commodity in the two different
markets. Suppose an equity share is quoted at Rs 1000 in the stock market and at
Rs 105 in the futures market. An arbitrageur would buy the stock at Rs 1000 in the
stock market and sell it at Rs 1050 in the futures market. In this process, he/she
earns a low-risk profit of Rs 50.
4. Margin traders

In the finance industry, 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. A margin refers to the minimum amount that you need to deposit
with the broker to participate in the derivative market. It is used to reflect your
losses and gains on a daily basis as per market movements. It enables to get
leverage in derivative trades and maintain a large outstanding position. Imagine
that with a sum of Rs. 2 lakh you buy 200 shares of ABC Ltd. of Rs 1000 each in
the stock market. However, in the derivative market, you can own a three times
bigger position i.e. Rs 6 lakh with the same amount. A slight price change will lead
to bigger gains/losses in the derivative market as compared to the stock market.

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 its option period. On the other hand,
European options can only be exercised on its expiration date. Options are of 2
types: – Call option and Put option. Call option provides the buyer a right but not
an obligation to buy an asset at the pre-decided price at some future date. On the
other hand, the put option provides the buyer a right but is not under any obligation
to sell an asset at some future date at the agreed price.

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, forwards 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 swaps contracts to be
customizable to suit the needs and requirements of both parties involved.

Swaps are derivative contracts wherein two parties exchange their financial
obligations. The cash flows are based on a notional principal amount agreed
between both parties without exchange of principal. The amount of cash flows is
based on a rate of interest. One cash flow is generally fixed and the other changes
on the basis of a benchmark interest rate. Swaps are the most complicated type of
derivative contracts which are entered into for exchanging cash flows in the future
between 2 parties..

Difference between cash and derivative market:

Difference between cash and derivative market:
 ▪ In cash market, we can purchase even one share whereas in case of
futures and options the minimum lots are fixed

▪ In cash market tangible assets are traded whereas in derivatives

contracts based on tangible or intangible assets are traded.

▪ Cash market is used for investment. Derivatives are used for hedging,
arbitrage or speculation.

▪ In case of cash market, a customer must open a trading and demat

account whereas for futures a customer must open a future trading
account with a derivative broker.

▪ In case of cash market, the entire amount is put upfront whereas in

case of futures only the margin money needs to be put up.

▪ When an individual buys shares, he becomes part owner of the

company whereas the same does not happen in case of a futures
contract.

▪ In case of cash market, the owner of shares is entitled to the

dividends whereas the derivative holder is not entitled to dividends.

Difference between forward and futures contract

▪ Forward contracts are traded on personal basis while future contracts

are traded in a competitive arena.
▪ Forward contracts are traded over the counter whereas futures are
exchange traded.

▪ Forward contracts settlement takes place on the date agreed upon

between the parties whereas futures contracts settlements are made
daily.
▪ Cost of forward contracts is based on bid- ask spread whereas futures
contract have brokerage fees for buy and sell order.

▪ In case of forwards, they are not subject to marking to market. On the

other hand, futures are marked to market.

▪ Margins are not required in case of forward market whereas in futures

margin is required

▪ In a forward contract, credit risk is borne by each party whereas in

case of futures the transaction is a 2 way transaction, hence both the
parties need not bother about the risk.
Types of Margin requirements

a) Initial margin
It is the initial cash that you must deposit in your account before you start trading.
This is required to ensure that the parties honor their obligation and provides a
cushion to the losses in the trade.
In simple words, it is like the down payment for the delivery of the contract.

b) Maintenance Margin
It is a cash balance which a trader must bring to maintain the account as it may
change due to price fluctuations.
The maintenance margin is a certain portion of the initial margin for a position
If the margin balance in the account goes below such margin, the trader is asked to
deposit required funds or collateral to bring it back to the initial margin
requirement.
This is known as a margin call.

How Margin Trading Works?

Margin trading is when the buyer of securities does not have to pay the entire
amount of money upfront in order to buy securities. Instead, they can only pay a
small percentage of the total value of the securities and take a position in the
security.
This can be better explained with the help of an example. Suppose an investor
wants to buy certain securities, the value of which is $100. The investor does not
have to pay $100 upfront. Instead, they can use the margin trading system. This
means that they will only put a certain amount, let’s say $10 and will borrow the
balance $90 from the broker. They will have to pay a nominal interest on these
$90. However, if the value of the security changes from $100 to $105, the
additional $5 will become available in the account of the investor. Instead, if the
value of this security goes down to $95, the investor will have to pay up the
additional $5 in order to maintain the margin.
In simple words, the $10 paid by the investor is the margin. This margin is used to
secure the interests of the people who have lent out the balance of $90. The
investor has to pay additional money as and when this value goes down. This value
needs to be maintained at $10 or any other value decided before borrowing funds.
Every time there is a shortage of funds, the broker sends out a call for additional
funds. This is called a margin call. If the investor is not able to pay up within a
specified amount of time, then the brokers have a right to sell off the asset, settle
the account and repay the balance amount payable to the investor.

Functions of derivatives market

Risk management: The prices of derivatives are related to their underlying

assets, as mentioned before. They can thus be used to increase or decrease the risk
of owning the asset. For example, you can reduce your risk by buying a spot item
and selling a futures contract or call option. This is how it works. If there is a fall
in the spot price, the corresponding futures and options contract will also fall. You
can repurchase the contract at a lower price, which will result in a gain. This can
partially offset the loss on the spot item. The ease of speculation in the derivatives
market makes it easier for an investor seeking to protect a position or an
anticipated position in the spot market.

Price discovery: Derivative market serves as an important source of information

about prices. Prices of derivative instruments such as futures and forwards can be
used to determine what the market expects future spot prices to be. In most cases,
the information is accurate and reliable. Thus, the futures and forwards markets are
especially helpful in price discovery mechanism.

Operational advantages: Derivative markets have greater liquidity than the

spot markets. The transactions costs therefore, are lower. This means commissions
and other costs for traders is lower in derivatives markets. Further, unlike securities
markets that discourage shorting, selling short is much easier in derivatives.
Lower Transaction Cost
The cost of trading in derivative instruments is quite low as compared to other
segments in financial markets. They act as a risk management tool and thereby
lower the transaction costs of the market.
Higher Leverage
Derivatives instruments provide higher leverage than any other instrument
available in the financial market. Capital required to take positions in derivative
instruments is very low as compared to the stock market. In the case of a future
contract, only 20-40% of the contract value is needed whereas, in case of options,
only the amount of premium is required for trading.

Enhance Market Efficiency

Derivatives plays an efficient role in improving the financial market’s efficiency.
These contracts are used for replicating the assets payoff. It enables in getting fair
and correct economic value of underlying commodity as these contracts brings
price corrections via arbitrage. This way market becomes price efficient and an
equilibrium is attained.