Understanding Derivatives

Derivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like

  • Commodities including grains, coffee beans, etc.
  • Precious metals like gold and silver
  • Foreign exchange rate
  • Bonds of different types, including medium to long-term negotiable debt securities issued by governments, companies, etc.
  • Short-term debt securities such as T-bills
  • Over-The-Counter (OTC) money market products such as loans or deposits
  • Equities

For example, a dollar forward is a derivative contract, which gives the buyer a right & an obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot prices of these underlying assets

However, the most important use of derivatives is in transferring market risk, called Hedging, which is a protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management.

There are various derivative products traded. They are;

  1. Forwards
  2. Futures
  3. Options
  4. Swaps
Uses of Financial Derivatives

Derivatives are supposed to provide some services and these services are used by investors. Some of the uses and applications of financial derivatives can be enumerated as following:

  1. Management of risk: One of the most important services provided by the derivatives is to control, avoid, shift and manage efficiently different types of risk through various strategies like hedging, arbitraging, spreading etc. Derivative assist the holders to shift or modify suitable the risk characteristics of the portfolios. These are specifically useful in highly volatile financial conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary chaos.
  2. Price discovery: The important application of financial derivatives is the price discovery which means revealing information about future cash market prices through the future market. Derivative markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking.
  3. Liquidity and reduce transaction cost : As we see that in derivatives trading no immediate full amount of the transaction is required since most of them are based on margin trading. As a result, large number of traders, speculators, arbitrageurs operates in such markets. So, derivatives trading enhance liquidity and reduce transaction cost in the markets of underlying assets. Measurement of Market: Derivatives serve as the barometers of the future trends in price which result in the discovery of new prices both on the spot and future markets. They help in disseminating different information regarding the future markets trading of various commodities and securities to the society which enable to discover or form suitable or correct or true equilibrium price in the markets. As a result, the assets will be in an appropriate and superior allocation of resources in the society.
  4. . Efficiency in trading: Financial derivatives allow for free trading of risk components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instruments in cash market.
  5. Speculation and arbitrage: Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to derivative contract when the future market price is low. Individual and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset
  6. Hedging : Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out. Hedging also occurs when an individual or institution buys an asset and sells it using a future contract. They have access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract of course; this allows them the benefit of holding the asset.
  7. Price stabilization function: Derivative market helps to keep a stabilizing influence on spot prices by reducing the short term fluctuations. In other words, derivatives reduce both peak and depths and lends to price stabilization effect in the cash market for underlying asset
  8. Gearing of value: Special care and attention about financial derivatives provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative
  9. Develop the complete markets : It is observed that derivative trading develop the market towards “complete markets” complete market concept refers to that situation where no particular investors be better off than others, or patterns of returns of all additional securities are spanned by the already existing securities in it, or there is no further scope of additional security
  10. Encourage competition : The derivatives trading encourage the competitive trading in the market, different risk taking preference at market operators like speculators, hedgers, traders, arbitrageurs etc. resulting in increase in trading volume in the country. They also attract young investors, professionals and other experts who will act as catalysts to the growth of financial market
  11. Other uses : The other uses of derivatives are observed from the derivatives trading in the market that the derivatives have smoothen out price fluctuations, squeeze the price spread, integrate price structure at different points of time and remove gluts and shortage in the markets. The derivatives also assist the investors, traders and managers of large pools of funds to device such strategies so that they may make proper asset allocation increase their yields and achieve other investment goals.

Types And Classification of DERIVATIVES

There are many ways in which the derivatives can be categorized based on the markets where they trade; based on the underlying asset and based on the product feature etc. some ways of classification are following:

(1) On the basis of linear and non-linear: On the basis of this classification the financial derivatives can be classified into two big class namely linear and non-linear derivatives:

(a) Linear derivatives: Those derivatives whose Over-the-counter (OTC) traded derivative: These values depend linearly on the underlying value are called linear derivatives. They are following:

(i) Forwards

(ii) Futures

(iii) Swaps

(b) Non-linear derivatives: Those derivatives whose value is a non-linear function of the underlying are called non-linear derivatives. They are following:

(i) Options

(ii) Convertibles

(iii) Equity linked bonds

(iv) Reinsurance

(2) On the basis of financial and non-financial: On the basis of this classification the derivatives can be classified into two category namely financial derivatives and non-financial derivatives.

(a) Financial derivatives: Those derivatives which are of financial nature are called financial derivatives. They are following:

(i) Forwards

(ii) Futures

(iii) Options

(iv) Swaps

The above financial derivatives may be credit derivatives, forex, currency fixed-income, interest, insider trading and exchange traded.

(b) Non-financial derivatives: Those derivatives which are not of financial nature are called non-financial derivatives. They are following:

(i) Commodities

(ii) Metals

(iii) Weather

(iv) Others

(3) On the basis of market where they trade: On the basis of this classification, the derivatives can be classified into three categories namely; OTC traded derivatives, exchange-traded derivative and common derivative. Derivative contracts are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. The OTC derivative market is the largest market for derivatives and largely unregulated with respect to disclosure of information between parties. They are following:

(i) Swaps

(ii) Forward rate agreements

(iii) Exotic options

(iv) Other exotic derivative

(b) Exchange traded derivative: Those derivative instruments that are traded via specialized derivatives exchange of other exchange. A derivatives exchange is a market where individual trade standardized contracts that have been defined by the exchange. Derivative exchange act as an intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee. They may be followings:

(i) Futures

(ii) Options

(iii) Interest rate

(iv) Index product

(v) Convertible

(vi) Warrants

(vii) Others

(c) Common derivative: These derivatives are common in nature/trading and classification. They are following:

(i) Forwards

(ii) Futures

(iii) Options

(iv) Binary options

(v) Warrant

(vi) Swaps

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