by Derivatives serve as financial contracts of a kind, in which their value depends on some underlying asset or a group of such assets. Some of the most commonly used derivatives are bonds, stocks, commodities, currencies, and indices. Since the value of the assets which control the derivative value fluctuates occasionally, the derivative to does not have a fixed value. Market conditions play an important role in deciding the value of a derivative. The basic guiding principle of derivative trading is that the buyer successfully predicts market changes to earn profits from their contracts. When the price of the asset on which the derivative depends falls, you will meet with a loss, whereas a surge in price, results in a profit. Therefore, trading in derivatives is about being able to predict the rise and fall of the asset and timing your exit and entry into the market subsequently.
Important Features of Derivatives
Derivative can be defined as a contract or an agreement for exchange of payments, whose value is derived from the value of an underlying asset. In simple words the price of derivative depends on the price of other assets.
Here are some of the features of derivative markets:
Derivative are of three kinds future or forward contract, options and swaps and underlying assets can be foreign exchange, equity, commodities markets or financial bearing assets.
As all transactions in derivatives takes place in future specific dates it is easier to short sell then doing the same in cash markets because an individual can take of markets and take the position accordingly because one has more time in derivatives.
Since derivatives have standardized terms due to which it has low counterparty risk, also transactions costs are low in derivative market and hence they tend to be more liquid and one can take large positions in derivative markets quite easily.
When value of underlying assets change then value of derivatives also changes and hence one can construct portfolio which is needed by one and that too without having the underlying asset. So for example if one want to buy some stock and short the market then he can buy the future of a stock and at the same time short sell the market without having to buy or sell the underlying assets.
Characteristics of Derivatives
Derivatives have the characteristic of Leverage or Gearing. With a small initial outlay of funds (a small percentage of the entire contract value) one can deal big volumes.
Pricing and trading in derivatives are complex and a thorough understanding of the price behaviour and product structure of the underlying is an essential pre-requisite before one can venture into dealing in these products. Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments.
Functions of Derivatives
Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools.
Derivatives improve the liquidity of the underlying instrument. Derivatives perform an important economic function viz. price discovery. They provide better avenues for raising money. They contribute substantially to increasing the depth of the markets.
Derivatives may have found their way into the media in very recent times. However, they have been used by mankind for a very long time. Since the inception of time, humans have not liked the idea of uncertainty. More so, they did not like the idea of economic uncertainty. Hence, the need to offset this uncertainty gave rise to the evolution of contracts. Earlier contracts were verbal agreements and were not as sophisticated as the ones today. However, they were contracts nonetheless. In this article, we will trace the evolution of derivatives throughout the ages.
Ancient Examples
Derivatives are said to have existed even in cultures as ancient as Mesopotamia. It was said that the king had passed a decree that if there was insufficient rain and therefore insufficient crop, the lenders would have to forego their debts to the farmers. They would simply have to write it off. Thus, the farmers had just been given a put option by the king. If certain events unfolded in a certain way they had the right to simply walk out of their liabilities!
There have been many such examples that have been quoted during the time. Another famous example pertains to Greek civilization when one of Aristotle’s followers who was adept at studying meteorology predicted that there would be a bumper crop of olives that year. He was so sure that he went ahead and purchased the produce of all the Olive farms in and around Athens before the crop had been harvested. In the end it did turn out to be a bumper crop and Aristotle’s disciple made a huge profit from his way ahead of time forwards contract.
19th Century: Chicago Board Of Trade
During the nineteenth century, America was at its pinnacle of economic progress. America was the center of innovation. One such innovation came in the field of exchange traded derivatives when farmers realized that finding buyers for the commodities had become a problem. They created a joint market called the “Chicago Board of Trade”. A few years later, this market evolved into the first ever derivatives market. Instead of buyers and sellers negotiating their own customized contracts, there were now standard contracts listed on the exchange which could be bought and sold by anyone. This idea proved to be a big hit. Soon Chicago Board of Trade had to create a spinoff called Chicago Mercantile Exchange to handle the growing business.
Recently Chicago Board of Trade and Chicago Mercantile Exchange have been merged to form the CME group. It is still one of the foremost derivatives markets in the world. The massive success witnessed by the members of the Chicago Board of Trade led to the creation of many such exchanges across the globe. However, during the era of Chicago Board of Trade, derivatives trading was limited to commodities only. Other financial instruments were largely outside the realm of such trading.
Modern Day
Innovations in the modern financial market have largely been based on the idea of derivatives. What started as a simple idea in ancient times was later developed into standard contracts during the Chicago Board of Trade era has now become a maze of complex financial instruments and contracts. The asset classes on which the derivative instruments were based have undergone a rapid expansion. Nowadays, there is a derivative for pretty much everything.
We have derivatives for stocks, indices, commodities, real estate etc. We even have derivatives that are based on other derivatives creating a Meta structure of sorts. The reason behind this rapid expansion is that derivatives meet the needs of a large number of individuals and businesses worldwide.
After the collapse of 2008, derivatives had to take the fall for the entire chain of events. They were vilified by the media in general. That has come as somewhat of a setback. Barring that the rise of derivatives in the recent years has been nothing short of extraordinary and this is expected to continue in the future.
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