Understanding the world of Derivatives

12 Mar 2020

The term Derivatives can be defined as a contract between two or more people whose value has been derived from an underlying asset, which has been agreed upon.

Let’s try to understand this concept with a simple real-life example. Suppose there is a cricket match going to be conducted, and on 1st April, its tickets are open for sale. Let's assume the price of 1 ticket to be Rs. 5,000. Suppose you go to buy the ticket for that cricket match, but it turns out that all the tickets of that cricket match have been sold out.

Fortunately, you have a friendship with a person working in the ticket department. He doesn’t give you the ticket directly, but he gives you a letter, i.e. a contract which states that you can buy the ticket of the cricket match anytime at the value of Rs. 5,000. Now suppose, two days before the game, there is a hike in the price of the ticket for that match—the price of the ticket increases to Rs. 7,000. Therefore, if you go to buy the ticket now using the letter, you can still purchase it at Rs. 5,000. Thus, the worth of that letter is Rs. 2,000, i.e. you have a profit of Rs. 2,000.

Take another scenario, suppose you were not able to go for the match that day. Therefore, the contract’s worth became NIL as the game is over, and now you cannot exchange the contract for the ticket of that match. This real-life example shows that a derivative is a contract whose value is determined from its underlying asset. Here, the letter was not any product; it was just a contract through which you could buy a ticket for a cricket match. The letter doesn’t have any direct value. Its value is derived or dependent on the match ticket’s value.

In economic terms, a derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or a set of assets (like an index). A derivative is basically a hedging and trading instrument. Being a margin-based trading instrument, it provides excellent leverage opportunities, which ultimately gives rise to speculation. Standard underlying instruments for derivatives include bonds, commodities, currencies, interest rates, market indexes, and stocks. Forwards, Futures, Options and Swaps are a popular form of financial derivatives which are used for trading.

Forwards and Futures - Financial contracts that obligate the contracts’ buyers to purchase an asset at a pre-agreed price on a specified future date are called forwards and futures. Forwards are more flexible contracts as these are customised according to the needs; meanwhile, futures are standardized contracts that are traded on the exchanges.

Options - Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date (European options) or on any date before the maturity (American options).

Swaps - Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of fixed cash flow for floating cash flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.

But what are some of the advantages of investing in this financial product? And are there any disadvantages to this? Let us discuss some pros and cons of the financial derivatives in greater detail below.

Pros of derivatives:-

  • Enable price discovery - The fact is that the derivatives encourage anyone that’s focused on speculation, hedging, and arbitrage to increase the competition in the markets. If there is any change in the price, then this attracts the attention of the speculators in the markets - this participation of those involved in the markets will make sure that there will be a fair price set in place. In the end, the result is a lot more efficient and effective discovery of the price of assets.
  • Useful for risk management - Hedging is a strategy that you can use to reduce the risks when it comes to holding a particular market position. Speculation, on the other hand, means that you’ll use strategies to take a new position in the market according to its projected movements. Both the speculation and the hedging strategy, alongside the derivatives, are handy tools for risk management.
  • Stable Market - The derivative financial instruments help create a more stable market in the sense that they provide a safety net against potentially adverse outcomes.
  • Reduce Costs - Since there are many participants in the market, it remains that there will be low transactional costs.

Cons of derivatives:-

  • High volatility - The derivatives raise the volatility in the markets. They do this by leading to speculation due to the fact that there are a large number of investors that make small investments.
  • High leverage - The high leverage of derivatives can result in greater profits, but that comes with the cost of increased risks, which may be translated, if things don't go well, into more significant losses. The derivatives can lead to a higher number of bankruptcies. The participants in the derivatives market often take a position that doesn’t match their real financial capabilities - this can lead to bankruptcy down the road.

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