DERIVATIVE MARKETS
Learning Objectives:
1. Explain how Derivative Financial Instruments work
2. Discuss the characteristics and examples of Derivative Financial Instruments
Derivatives: Meaning, Features, and Importance
Derivatives
are financial instruments that derive their value on contractually required cash flows from some
other security or index.
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.
They are complex financial instruments that are used for various purposes,
including hedging and getting access to additional assets or markets.
Characteristics of Derivatives
A derivative is a financial instrument:
a) whose value changes in response to the change in a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or similar variable
b) that requires no initial net investment or little net investment relative to other types of
contracts that have a similar response to changes in market conditions; and
c) that is settled at a future date.
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.
How it works
Investors may buy derivatives in order to reduce the amount of volatility in their
portfolios, since they can agree on a price for a deal in the present that will, in effect,
happen in the future, or to try to increase their gains through speculation.
It can enable an investor to gain exposure to a market via a smaller outlay than if they
bought the actual underlying.
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.
TYPICAL EXAMPLES OF DERIVATIVES
Feature Options Swaps Futures Forward Contracts
Contracts giving the right,
but not the obligation, to Agreements to exchange Standardized Custom agreements to
buy or sell an asset at a cash flows or other contracts to buy or buy or sell an asset at a
specified price before a financial instruments sell an asset at a specified future date
Definition specified date. over a set period. future date and price. and price.
Interest rate swaps, Commodity futures,
Types Call options, put options currency swaps financial futures Tailored contracts
Exchanges (e.g., CME,
Traded On Exchanges (e.g., CBOE) Over-the-counter (OTC) NYMEX) Over-the-counter (OTC)
Standardization Standardized Customizable Highly standardized Customizable
Regulated by financial Less regulated, largely Highly regulated by Less regulated, largely
Regulation authorities (e.g., SEC) OTC financial authorities OTC
Depends on the Subject to margin Depends on the
Limited to the premium counterparties' credit requirements and counterparties' credit
Risk paid risk daily settlements risk
Hedging, interest rate Hedging, speculation,
Use Cases Hedging, speculation management price discovery Hedging, speculation
Feature Options Swaps Futures Forward Contracts
American (anytime before
expiration) or European (at
Exercise Style expiration) N/A N/A N/A
Cash flows exchanged Usually cash settled Physical or cash
Settlement Physical or cash settlement periodically daily settlement
Swapping fixed interest Agreeing to buy euros
Buying a call option on payments for floating Trading a crude oil in six months at a fixed
Examples Apple stock rate payments futures contract rate
Advantages of Derivatives
1. Hedging risk exposure
Since the value of the derivatives is linked to the value of the underlying asset, the
contracts are primarily used for hedging risks. For example, an investor may purchase a derivative
contract whose value moves in the opposite direction to the value of an asset the investor owns.
In this way, profits in the derivative contract may offset losses in the underlying asset.
2. Underlying asset price determination
Derivatives are frequently used to determine the price of the underlying asset. For
example, the spot prices of the futures can serve as an approximation of a commodity price.
3. Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using
derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the
underlying asset and the associated derivative tend to be in equilibrium to
avoid arbitrage opportunities.
4. Access to unavailable assets or markets
Derivatives can help organizations get access to otherwise unavailable assets or markets. By
employing interest rate swaps, a company may obtain a more favorable interest rate relative to
interest rates available from direct borrowing.
Disadvantages of Derivatives
1. High risk
The high volatility of derivatives exposes them to potentially huge losses. The sophisticated
design of the contracts makes the valuation extremely complicated or even impossible. Thus,
they bear a high inherent risk.
2. Speculative features
Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of
derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.
3. Counter-party risk
Although derivatives traded on the exchanges generally go through a thorough due diligence
process, some of the contracts traded over-the-counter do not include a benchmark for due
diligence. Thus, there is a possibility of counter-party default.
References:
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Vakilsearch. (n.d.). Derivatives: Meaning, features, and importance. Vakilsearch. Retrieved May 17, 2024
Corporate Finance Institute. (n.d.). Derivatives. Corporate Finance Institute. Retrieved May 17, 2024,
Hull, J. C. (2018). Options, futures, and other derivatives (10th ed.). Pearson.
Fabozzi, F. J., & Mann, S. V. (2005). Handbook of fixed-income securities. McGraw-Hill.
Kolb, R. W., & Overdahl, J. A. (2010). Financial derivatives: Pricing and risk management. John Wiley &
Sons.
Madura, J. (2018). Financial markets and institutions (12th ed.). Cengage Learning.
