Participants in the Derivatives Market
The participants in the derivatives market can be broadly categorized into the following
four groups:
1. Hedgers
Hedging is when a person invests in financial markets to reduce the risk of price
volatility in exchange markets, i.e., eliminate the risk of future price movements.
Derivatives are the most popular instruments in the sphere of hedging. It is because
derivatives are effective hedges in correspondence with their respective underlying
assets.
2. Speculators
Speculation is the most common market activity that participants of a financial market
take part in. It is a risky activity that investors engage in. It involves the purchase of any
financial instrument or an asset that an investor speculates to become significantly
valuable in the future. Speculation is driven by the motive of potentially earning lucrative
profits in the future.
3. Arbitrageurs
Arbitrage is a very common profit-making activity in financial markets that comes into
effect by taking advantage of or profiting from the price volatility of the market.
Arbitrageurs make a profit from the price difference arising in an investment of a
financial instrument such as bonds, stocks, derivatives, etc.
4. Margin traders
In the finance industry, the margin is the collateral deposited by an investor investing in
a financial instrument to the counterparty to cover the credit risk associated with the
investment.
Types of Derivative Contracts
Derivative contracts can be classified into the following four types:
1. Options
Options are financial derivative contracts that give the buyer the right, but not the
obligation, to buy or sell an underlying asset at a specific price (referred to as the strike
price) during a specific period of time. American options can be exercised at any time
before the expiry of its option period. On the other hand, European options can only be
exercised on its expiration date.
2. Futures
Futures contracts are standardized contracts that allow the holder of the contract to
buy or sell the respective underlying asset at an agreed price on a specific date. The
parties involved in a futures contract not only possess the right but also are under the
obligation, to carry out the contract as agreed. The contracts are standardized, meaning
they are traded on the exchange market.
3. Forwards
Forwards contracts are similar to futures contracts in the sense that the holder of the
contract possess not only the right but is also under the obligation to carry out the
contract as agreed. However, forwards contracts are over the counter products, which
means they are not regulated and are not bound by specific trading rules and
regulations.
Since such contracts are unstandardized, they are traded over the counter and not on
the exchange market. As the contracts are not bound by a regulatory body’s rules and
regulations, they are customizable to suit the requirements of both parties involved.
4. Swaps
Swaps are derivative contracts that involve two holders, or parties to the contract, to
exchange financial obligations. Interest rate swaps are the most common swaps
contracts entered into by investors. Swaps are not traded on the exchange market. They
are traded over the counter, because of the need for swaps contracts to be
customizable to suit the needs and requirements of both parties involved.
Criticisms of the Derivatives Market
1. Risk
The derivatives market is often criticized and looked down on, owing to the high risk
associated with trading in financial instruments.
2. Sensitivity and volatility of the market
Many investors and traders avoid the derivatives market because of its high volatility.
Most financial instruments are very sensitive to small changes such as a change in the
expiration period, interest rates, etc., which makes the market highly volatile in nature.
3. Complexity
Owing to the high-risk nature and sensitivity of the derivatives market, it is often a very
complex subject matter. Because the derivatives trading is so complex to understand, it
is most often avoided by the general public, and they often employ brokers and trading
agents in order to invest in financial instruments.
4. Legalized gambling
Owing to the nature of trading in financial markets, derivatives are often criticized for
being a form of legalized gambling, as it is very similar to the nature of gambling
activities.
1. Asymmetric information, also known as "information failure," occurs when
one party to an economic transaction possesses greater material
knowledge than the other party.
2.
3. Asymmetric information typically manifests when the seller of a good or
service possesses greater knowledge than the buyer; however, the
reverse dynamic is also possible. Almost all economic transactions involve
information
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/derivatives-market/
https://www.investopedia.com/terms/a/asymmetricinformation.asp
