Important Features of Derivatives

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.

Why invest in derivative contracts?

Earning profits is not the only reason investors flock towards derivative contracts. One of the biggest reasons investors prefer derivatives is because it gives them an Arbitrage advantage. This comes as a result of buying an asset at a low price and then selling it at a higher price in another market. This way, the buyer is protected by the difference in the value of the product in the different markets, and thereby, gets an added benefit from both markets. Furthermore, certain derivative contracts protect you from market volatility and help shield your assets against fall in stock prices. If that wasn’t enough, derivative contracts are also a great way to transfer risk and balance out your portfolio.

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

1. 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.
2. 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.
3. Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments.

Functions of Derivatives

1. Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools.
2. 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.

Users of Derivatives

Hedgers, Traders and Speculators use derivatives for different purposes. Hedgers use derivatives to protect their assets/posi­tions from erosion in value due to market volatility. Traders look for enhancing their income by making a two-way price for other market participants. Speculators set their eyes on making quick money by taking advantage of the volatile price movements.

Hedging is a mechanism by which an investor seeks to protect his asset from erosion in value due to adverse market price move­ments. A Hedger is usually interested in streamlining his future cash flows. He is most concerned when the market prices are very volatile. He is not concerned with future positive potential of the value of underlying asset.

A speculator has, normally, no asset in his possession to protect. He is not concerned with stabilising his future cash flows. He is interested only in making quick money by taking advantage of the price movements in the market. He is quite happy with volatility. In fact, volatility is his daily bread and butter.

Arbitrageurs also form a segment of the financial markets. They make riskless profit by exploiting the price differentials in differ­ent markets. For example, if a company’s shares were trading at Rs. 3500 in Mumbai market and Rs.3498 in Delhi market, an arbitrageur will buy it in Delhi and sell it in Mumbai to make a riskless profit of Rs. 2 (transaction cost is ignored for the purpose of this example).

Successive such transactions will iron out the difference in prices and bring equilibrium in the market. How­ever, arbitraging is not a very safe way of making money as was proved in the case of Barings Bank where unscrupulous arbitraging between Osaka and Tokyo exchanges in Nikkei Stock index futures drove the Bank to bankruptcy.

Salient Points of Derivatives

1. Financial Derivatives are products whose values are derived from the values of the underlying assets.
2. Derivatives have the characteristics of high leverage and of being complex in their pricing and trading mechanism.
3. Derivatives enable price discovery, improve the liquidity of the underlying asset, serve as effective hedge instruments and offer better ways of raising money.
4. The main players in a financial market include hedgers, speculators, arbitrageurs and traders.
5. Hedging can be done in two ways viz. fixing a price (the linear way) and taking an insurance (non-linear or asymmetric way).

There are a number of derivative contracts. Basically they are forwards, futures and options. Forwards are definitive purchases and/or sales of a currency or commodity for a future date. Forward contracts are contracted for a particular value and should be transacted on a given date.

Forwards are useful in avoiding liquidity risk, price variations and locking in avoiding a downside. Forward however has the limitation that the contract has to be performed in full and has attendant credit risk and market risk. Forwards are most useful in forex transactions where a spot transaction can be covered by a contrary move in the forward market.