Derivatives: Meaning, Features, and Importance

Last Updated at: May 28, 2020
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Derivatives_ Meaning, Features and Importance
In first week of May, 2020, India made a valiant attempt to bring home trading volumes in rupee derivatives from offshore markets. It launched rupee-dollar futures and options contracts on two international exchanges — BSE’s India INX and NSE’s NSE-IFSC . The new contracts are anticipated to draw traders and hedgers into the home market and help create a vibrant foreign exchange market in India.

 

Derivatives act as contracts whose value comes from some underlying asset related to it, and all across the country, they are used to trade and make money. While they might not be the easiest asset to figure out, there are several advantages in using them, as they allow you to even out your risks. Here’s a look at everything you need to know about derivatives and why they are so important.

  1. What are derivatives?

  2. Why invest in derivative contracts?

  3. Participants of the derivatives market

  4. Major Derivative Types

  5. Features of Trading in the Derivatives Market

 

What are 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.

Get FREE legal advice now

Participants of the derivatives market

  1. Hedgers:

    Risk-averse brokers and traders who wish to play it safe in the stock market. Rather than invest in tricky stocks which may give them either a huge profit or a huge loss, hedgers invest their money in derivative markets, in a bid to protect their portfolio. By assuming an opposite position concerning the derivatives market, they can protect themselves against market risk and price fluctuations.

  2. Speculators:

    They are the primary risk-takers of any derivative market as they don’t mind taking risks to earn large profits. Therefore, they have a frame of mind that is the polar opposite to the one possessed by hedgers, who wish to play safe always.

  3. Margin Traders:

    Margin is the bare minimum that an investor needs to pay the broker to take part in derivatives trading. This margin is a form of representing market fluctuations as it reflects the loss or gain made on that day.

  4. Arbitrageurs:

    They make use of market imperfections to make money by buying low-priced stocks and then selling them at higher prices in a different market. However, this becomes possible only if the commodity in question is priced differently in different markets.

Major Derivative Types

  • Options

These derivative contracts allow buyers to sell or buy an underlying asset within a specified time interval at a particular price. In such cases, the one who sells the option is called an option writer and the price at which the option is sold is referred to as strike price. However, the buyer does not necessarily have to exercise the option. There are various foreign options and they differ in their manner of operation. For instance, an American option may be exercised any time before expiry, whereas a European option can be used only on the day of its expiry.

  • Futures

These standardized contracts allow individuals to sell or buy an asset on a particular day at a specific price. However, unlike options, the parties who enter into futures are bound to make the transaction on the prescribed day. Such derivatives are commonly traded and transacted on the stock exchange, with their every-day value fluctuating as per the market trend.  

  • Forwards

Forwards are unstandardized futures that do not have a presence on the stock market. However, much like futures, the people who are a part of such a contract are bound to exercise it. Forwards are traded over-the-counter and can be customized as per the requirements of the traders themselves.

  • Swaps

These derivative contracts enable two individuals to exchange their financial obligations. And the resulting cash flow has a rate of interest attached to it. While one cash flow remains fixed, the other fluctuates based on the interest rate. Swaps are also over-the-counter derivatives, which are not traded on stock exchanges.

Features of Trading In the Derivatives Market

  1. Investors should take care to study the derivatives market before trading as their rules. And regulations are quite different from that of the stock market.
  2. Before you begin trading, individuals must deposit a margin amount, which once paid, cannot be withdrawn until after the trade is settled. Furthermore, if it ever falls below the required amount, the individual must replenish it before continuing to trade. 
  3. To trade on the derivatives market, the trader must possess an active trading account with a permit for derivative trading. 
  4. To buy stocks, traders must look at factors such as cash available, margins, contract price and price of shares.
  5. As transactions occur in the future, within the market, it is easier to short sell
  6. The market has low transaction costs as the market is heavily standardised owing to low risk
  7. The most important underlying assets which determine the cost of a derivative are stock prices, exchange rates and interest rates
  8. In some cases, derivatives can also be used to determine prices of the underlying assets
  9. They also help in improving the efficiency of financial markets by allowing better accessibility and visibility
  10. However, the high volatility of the derivative market results in huge losses if uncalculated steps are taken. And hence, investors must be very careful while investing in derivatives.

 

0

Derivatives: Meaning, Features, and Importance

547
In first week of May, 2020, India made a valiant attempt to bring home trading volumes in rupee derivatives from offshore markets. It launched rupee-dollar futures and options contracts on two international exchanges — BSE’s India INX and NSE’s NSE-IFSC . The new contracts are anticipated to draw traders and hedgers into the home market and help create a vibrant foreign exchange market in India.

 

Derivatives act as contracts whose value comes from some underlying asset related to it, and all across the country, they are used to trade and make money. While they might not be the easiest asset to figure out, there are several advantages in using them, as they allow you to even out your risks. Here’s a look at everything you need to know about derivatives and why they are so important.

  1. What are derivatives?

  2. Why invest in derivative contracts?

  3. Participants of the derivatives market

  4. Major Derivative Types

  5. Features of Trading in the Derivatives Market

 

What are 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.

Get FREE legal advice now

Participants of the derivatives market

  1. Hedgers:

    Risk-averse brokers and traders who wish to play it safe in the stock market. Rather than invest in tricky stocks which may give them either a huge profit or a huge loss, hedgers invest their money in derivative markets, in a bid to protect their portfolio. By assuming an opposite position concerning the derivatives market, they can protect themselves against market risk and price fluctuations.

  2. Speculators:

    They are the primary risk-takers of any derivative market as they don’t mind taking risks to earn large profits. Therefore, they have a frame of mind that is the polar opposite to the one possessed by hedgers, who wish to play safe always.

  3. Margin Traders:

    Margin is the bare minimum that an investor needs to pay the broker to take part in derivatives trading. This margin is a form of representing market fluctuations as it reflects the loss or gain made on that day.

  4. Arbitrageurs:

    They make use of market imperfections to make money by buying low-priced stocks and then selling them at higher prices in a different market. However, this becomes possible only if the commodity in question is priced differently in different markets.

Major Derivative Types

  • Options

These derivative contracts allow buyers to sell or buy an underlying asset within a specified time interval at a particular price. In such cases, the one who sells the option is called an option writer and the price at which the option is sold is referred to as strike price. However, the buyer does not necessarily have to exercise the option. There are various foreign options and they differ in their manner of operation. For instance, an American option may be exercised any time before expiry, whereas a European option can be used only on the day of its expiry.

  • Futures

These standardized contracts allow individuals to sell or buy an asset on a particular day at a specific price. However, unlike options, the parties who enter into futures are bound to make the transaction on the prescribed day. Such derivatives are commonly traded and transacted on the stock exchange, with their every-day value fluctuating as per the market trend.  

  • Forwards

Forwards are unstandardized futures that do not have a presence on the stock market. However, much like futures, the people who are a part of such a contract are bound to exercise it. Forwards are traded over-the-counter and can be customized as per the requirements of the traders themselves.

  • Swaps

These derivative contracts enable two individuals to exchange their financial obligations. And the resulting cash flow has a rate of interest attached to it. While one cash flow remains fixed, the other fluctuates based on the interest rate. Swaps are also over-the-counter derivatives, which are not traded on stock exchanges.

Features of Trading In the Derivatives Market

  1. Investors should take care to study the derivatives market before trading as their rules. And regulations are quite different from that of the stock market.
  2. Before you begin trading, individuals must deposit a margin amount, which once paid, cannot be withdrawn until after the trade is settled. Furthermore, if it ever falls below the required amount, the individual must replenish it before continuing to trade. 
  3. To trade on the derivatives market, the trader must possess an active trading account with a permit for derivative trading. 
  4. To buy stocks, traders must look at factors such as cash available, margins, contract price and price of shares.
  5. As transactions occur in the future, within the market, it is easier to short sell
  6. The market has low transaction costs as the market is heavily standardised owing to low risk
  7. The most important underlying assets which determine the cost of a derivative are stock prices, exchange rates and interest rates
  8. In some cases, derivatives can also be used to determine prices of the underlying assets
  9. They also help in improving the efficiency of financial markets by allowing better accessibility and visibility
  10. However, the high volatility of the derivative market results in huge losses if uncalculated steps are taken. And hence, investors must be very careful while investing in derivatives.

 

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