Derivatives are widely used by investors and traders to manage risk, speculate on price movements, and to obtain leverage. There are two main types of derivatives: futures and options.
Futures contracts are agreements between two parties to buy or sell an asset at a predetermined price and date in the future. Futures contracts are standardized and traded on organized exchanges.
Options contracts, on the other hand, give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price and date in the future. Options contracts can be customized to meet the specific needs of the buyer and seller.
Derivatives can be used for a variety of purposes, including hedging, speculation, and arbitrage. Hedging involves using derivatives to reduce the risk of an existing investment, while speculation involves using derivatives to profit from anticipated price movements. Arbitrage involves taking advantage of price discrepancies between different markets or assets.
Derivatives are complex financial instruments and involve a high degree of risk. It is important for investors to have a thorough understanding of the underlying assets, as well as the mechanics of the derivative contract, before investing in derivatives.
Underlying Concept in Derivatives-
Zero Sum Game:
Derivative trading is a zero-sum game where one trader’s gain is another trader’s loss. The total amount of profit and loss in derivative trading is zero. This means that the total loss incurred by the losing party is equal to the total gain made by the winning party.
Settlement Mechanism:
Derivative contracts have a settlement mechanism that is either cash-settled or physically settled. In cash-settled contracts, the difference between the contract price and the underlying asset’s price is settled in cash. In physically settled contracts, the delivery of the underlying asset takes place on the expiry of the contract.
Arbitrage:
Arbitrage is the process of making profits by exploiting price differences in two different markets. In derivative trading, arbitrage opportunities arise due to price differences between the cash market and the derivative market.
Margining Process:
Margin is the amount that a trader deposits with the exchange or the broker to initiate a derivative trade. Margin requirements are specified by the exchange or the broker and depend on the volatility and liquidity of the underlying asset. The margining process helps to reduce counterparty risks in derivative trading.
Open Interest:
Open interest is the total number of outstanding contracts in a derivative market. It represents the total number of contracts that have not been exercised, closed out or expired. The open interest in a derivative market reflects the market’s liquidity and can be used to analyze market sentiment.
Types of derivative products:-
- Forwards:
A forward contract is an agreement between two parties to buy or sell an underlying asset at a specified price and on a specified date in the future. The price is agreed upon at the time of entering into the contract. The contract is settled on the delivery date, which can be any date that the buyer and seller agree upon.
Liquidity Risk:
One of the risks associated with forward contracts is liquidity risk. Since forward contracts are customized, they cannot be traded on a secondary market, which makes them less liquid than standardized contracts such as futures contracts.
Counterparty Risk:
Another risk associated with forward contracts is counterparty risk. Counterparty risk is the risk that the other party to the contract will default on its obligations. In the case of forward contracts, there is no margin system to protect against this risk, and hence it becomes important to choose the counterparty carefully.
Example:
Suppose a farmer wants to sell his crop to a mill owner at a specified price after a few months. The farmer enters into a forward contract with the mill owner to sell the crop at the agreed-upon price on the delivery date. Here, the farmer is hedging against the risk of falling prices of the crop, while the mill owner is hedging against the risk of rising prices.
- Futures:
Futures contracts are similar to forward contracts, but they are standardized contracts and traded on organized exchanges. Futures contracts have a standardized contract size, expiration date, and settlement mechanism. Futures contracts are marked to market daily, which means that the gains or losses are settled every day.
Example:
Suppose an investor wants to buy shares of a company after a few months. The investor can buy a futures contract of the same company on the exchange at the current market price. If the price of the shares rises, the investor will make a profit, and if the price falls, the investor will incur a loss.
- Options:
Options contracts give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price and on a specified date in the future. The buyer pays a premium to the seller for the option.
Example:
Suppose an investor wants to hedge against the risk of falling prices of a stock. The investor can buy a put option on the stock, which gives the investor the right to sell the stock at the specified price on the specified date. If the price of the stock falls, the investor can exercise the option and sell the stock at the higher price specified in the option.
- Swaps:
A swap is an agreement between two parties to exchange cash flows based on different financial instruments. Swaps can be used to manage interest rate risk, currency risk, or credit risk.
Example:
Suppose a company has taken a loan at a variable interest rate and wants to switch to a fixed interest rate. The company can enter into an interest rate swap agreement with a financial institution to exchange its variable interest payments for fixed interest payments. The financial institution will pay the company the difference between the fixed and variable interest rates.
Structure of derivative markets
The structure of derivative markets can be broadly categorized into two types – Over-The-Counter (OTC) markets and Exchange Traded Markets.
a. OTC Markets:
OTC markets are decentralized markets where the trading of derivative products takes place through private negotiations between two parties. The terms of the derivative contracts in OTC markets are customizable, which means the parties involved can agree on the terms of the contract, including the underlying asset, price, quantity, and settlement date. OTC markets do not have a standardized contract size, and the liquidity in OTC markets can vary depending on the demand for the underlying asset.
Example: A company may enter into an OTC derivative contract with a bank to hedge against foreign exchange risk. The bank would structure a derivative product according to the company’s specific needs, such as the currency pair, the notional amount, and the maturity of the contract.
b. Exchange Traded Markets:
Exchange Traded Markets are centralized markets where derivative products are traded on organized exchanges, such as the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE) in India. Exchange Traded Markets offer standardized derivative products with pre-determined contract specifications, such as the underlying asset, price, quantity, and settlement date. The standardized contract size and settlement mechanism in Exchange Traded Markets ensure that the market is highly liquid and transparent.
Example: Nifty futures are traded on the NSE, which is an example of an Exchange Traded Market. The Nifty futures contract has a standardized contract size of 75 shares, with a pre-determined expiration date and settlement mechanism. The contract is traded on the exchange’s electronic platform, and the market price of the contract is determined by the forces of supply and demand.
Structure of Derivatives Markets-
The purpose of derivatives can be broadly classified into three categories: hedging, speculation, and arbitrage.
- Hedging: Hedging is a risk management strategy that involves taking positions in derivatives to offset potential losses in an underlying asset. For example, an airline may use fuel futures contracts to hedge against the risk of rising fuel prices, while a farmer may use crop futures contracts to hedge against the risk of falling crop prices. In this way, derivatives allow market participants to manage risks and protect against adverse price movements in their underlying assets.
- Speculation: Speculation involves taking positions in derivatives with the aim of earning a profit from price movements in the underlying asset. Unlike hedging, speculation is not aimed at managing risk, but rather at taking advantage of market opportunities to generate returns. For example, a trader may take a long position in a stock futures contract if they believe the stock price will rise, or a short position if they believe it will fall.
- Arbitrage: Arbitrage involves taking advantage of price discrepancies between two or more markets to earn a riskless profit. Derivatives can be used in arbitrage strategies to profit from pricing inefficiencies in the underlying asset. For example, an arbitrageur may simultaneously buy and sell futures contracts on the same underlying asset in different markets to take advantage of price discrepancies, earning a profit without taking on any market risk.
Benefits, Costs, and Risks of Derivatives
Benefits of derivatives:
- Hedging: Derivatives provide a means for companies to hedge against risks, such as price fluctuations in commodities or currencies, thereby reducing the uncertainty and potential losses associated with such risks.
- Liquidity: Derivatives markets can provide liquidity to underlying markets, allowing market participants to buy and sell assets more easily.
- Price discovery: Derivatives markets can provide a mechanism for price discovery, as the price of a derivative can provide insight into the expected future price of the underlying asset.
Costs of derivatives:
- Complexity: Derivatives can be complex financial instruments that require specialized knowledge to understand and manage.
- Counterparty risk: In derivative transactions, there is a risk that the counterparty may default on the transaction, resulting in significant losses for the other party.
- Margin requirements: In some cases, derivatives transactions require margin payments, which can tie up capital and limit liquidity for market participants.
Risks of derivatives:
- Market risk: Derivatives are subject to market risk, meaning that the value of the derivative can change in response to changes in the market or underlying asset.
- Credit risk: Derivatives are also subject to credit risk, as the counterparty may default on the transaction.
- Operational risk: Derivatives transactions are subject to operational risk, such as errors in processing, settlement, or reporting.
It is important to note that the benefits and risks of derivatives can vary depending on the specific instrument and how it is used. When used appropriately, derivatives can provide significant benefits to market participants, but when used improperly, they can also result in significant losses. It is important for market participants to fully understand the benefits, costs, and risks associated with derivatives before using them in their investment strategies.
Equity, Currency, and Commodity derivatives
Equity derivatives, currency derivatives, and commodity derivatives are the three main types of derivatives.
- Equity derivatives: Equity derivatives are financial instruments that derive their value from the price of an underlying stock or stock index. Equity derivatives can be used to hedge against risks associated with equity investments or to speculate on future movements in equity prices. Examples of equity derivatives include options, futures, and swaps.
- Currency derivatives: Currency derivatives are financial instruments that derive their value from the price of an underlying currency exchange rate. Currency derivatives can be used to hedge against risks associated with currency fluctuations or to speculate on future movements in currency exchange rates. Examples of currency derivatives include forwards, options, futures, and swaps.
- Commodity derivatives: Commodity derivatives are financial instruments that derive their value from the price of an underlying commodity such as gold, silver, crude oil, agricultural commodities, etc. Commodity derivatives can be used to hedge against risks associated with commodity price fluctuations or to speculate on future movements in commodity prices. Examples of commodity derivatives include futures, options, and swaps.
Derivative markets, products and strategies
Derivative markets have become increasingly popular in recent years, as traders and investors seek new ways to manage risk and generate returns. Within this market, there are various products and strategies that can be used, each with their own advantages and risks. In this article, we will discuss several important topics in derivative markets, including pricing a future contract, spot-future arbitrage, option payoffs, payoff charts for options, long and short positions on options, hedging using futures, payoff structure, hedging using options, and the difference between futures and options in hedging.
Pricing a Future Contract:
A future contract is an agreement between two parties to buy or sell an underlying asset at a predetermined price and time in the future. The price of a future contract is determined by the spot price of the underlying asset, the cost of carry, and the risk-free rate of interest. The cost of carry includes storage costs, insurance costs, and other expenses related to holding the underlying asset. To price a future contract, traders use a mathematical formula called the cost of carry model, which takes into account these variables.
Spot-Future Arbitrage:
Spot-future arbitrage is a strategy used by traders to profit from price discrepancies between the spot price and future price of an asset. If the future price of an asset is higher than the spot price, traders can buy the asset at the spot price and sell it in the futures market at a higher price. Similarly, if the future price is lower than the spot price, traders can sell the asset in the spot market and buy it back in the futures market at a lower price. This strategy is based on the principle of no-arbitrage, which states that the price of an asset should be the same in all markets.
Option Payoffs:
An option is a derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and time in the future. The payoffs of an option depend on whether it is a call option or a put option. A call option gives the buyer the right to buy the underlying asset, while a put option gives the buyer the right to sell the underlying asset. The payoffs of an option also depend on the strike price and the spot price of the underlying asset at expiration.
Payoff Charts for Options:
Payoff charts are graphical representations of the payoffs of options at expiration. They show the potential profits and losses of options at different levels of the spot price of the underlying asset. These charts are useful for traders to visualize the risks and rewards of different options strategies.
Long and Short Positions on Options:
A long position on an option means that the buyer has purchased the option and has the right to exercise it. A short position on an option means that the seller has sold the option and is obligated to fulfill the terms of the contract if the buyer exercises it. Traders can take long or short positions on options depending on their market outlook and risk tolerance.
Hedging Using Futures:
Hedging is a strategy used by traders to reduce their exposure to risk. In the futures market, traders can use futures contracts to hedge against price fluctuations in the underlying asset. For example, if a company expects to buy a certain amount of oil in the future, it can buy a futures contract to lock in the price and protect against price increases.
Payoff Structure:
The payoff structure of a hedging strategy shows the potential profits and losses at different levels of the spot price of the underlying asset. The goal of hedging is to create a payoff structure that is neutral to price movements in the underlying asset, thereby reducing risk.
Hedging Using Options:
Traders can also use options contracts to hedge against price fluctuations in the underlying asset. This strategy is more flexible than hedging using futures, as options provide the buyer with the right, but not the obligation, to buy or sell the underlying asset at a predetermined price and time in the future. This means that the buyer can choose to exercise the option only if it is profitable to do so. However, options also have a cost, known as the option premium, which must be taken into account when hedging.
Future vs. Options in Hedging:
Both futures and options can be used for hedging purposes, but there are some differences between the two. Futures contracts are standardized and traded on exchanges, while options contracts can be customized and traded over the counter. Futures contracts have lower transaction costs, but options provide greater flexibility and limited downside risk. Traders must consider their specific hedging needs and market conditions when deciding whether to use futures or options for hedging.
