WHAT IS A DERIVATIVE
A Derivative is a financial contract/security that derives its value from an underlying asset. They are linked to other securities such as bonds and stocks, commodities, currencies, and interest rates. They are not worth anything in and of themselves as there value is based off primary security they are linked to. In each transaction, there is one party that wants to increase their exposure to risk and one party that is looking to take that risk.
Some uses of financial derivatives include management of risk, measurement of market, efficiency in trading, price discovery, hedging, price stabilization function, encourage competition, reduction in the transaction cost, etc.
FEATURES OF DERIVATIVES
Some of the striking features of derivatives include:
i. Transactions related to derivatives take place on a future date.
ii. A derivative can be used as leverage instruments.
iii. Derivatives have a maturity/expiring date.
iv. The derivatives market is liquid.
TYPES OF FINANCIAL DERIVATIVES
i. Options – These are contracts between parties to buy or sell a security at a given price. Derivatives market gives the trader the right to buy CALL or sell PUT an underlying asset. Options are flexible.
ii. Futures – Futures are same as options, although the underlying security is different.
iii. Swaps – They allow both the parties to exchange the benefits of their securities with each other.
USES OF DERIVATIVES
Some uses of Financial Derivatives are as follows:
i. Derivatives are used to control, avoid, shift, and manage different types of risks through various strategies like hedging, arbitraging, etc.
ii. Derivatives serve as barometers of the future trends in prices which results in the discovery of new prices.
iii. In derivatives trading, no full amount of the transaction is required.
iv. The derivatives assist the investors, traders, and managers to devise such strategies to achieve investment goals.
v. The derivatives trading develops the market towards complete markets.
This market is estimated to be roughly $1.2 quadrillion in size making it extremely large. Most of the investors prefer buying derivatives rather than the underlying asset. The market has 2 categories namely OTC derivatives and exchange-based derivatives.
OTC is not listed on the exchanges and is directly traded between parties. Exchange-based derivatives are listed on the exchanges and the contract is predetermined as they are public.
In India, the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are two major exchanges with other markets for derivatives. Both the markets have shown remarkable growth in terms of volume and numbers of traded contracts. Derivatives trading was introduced in 2000 and equity derivative market have registered an explosive growth.
ADVANTAGES AND DISADVANTAGES
Advantages include providing a way to lock in prices, hedge against risk often for a limited cost. Derivatives can often be purchased on margin thus making them less expensive. In all, they have a diverse portfolio.
Disadvantages/Risks are difficult to predict the value of derivatives, they are difficult to value as they are based on the price of another asset, overpriced options, and potential for scams. Most of the derivatives are sensitive to supply and demand factors, thus making it difficult to match the value of a derivative with the underlying asset. The derivative also has no intrinsic value.
WHO SHOULD INVEST IN DERIVATIVES
It is very tough for novice investors. Beginners should not take high risks in the market. Thus, it is made up of financial engineers, highly experienced investors, and professional money managers. Granted your experience and knowledge, the investment in derivatives should only make up of a percentage in the investment portfolio. As they are highly volatile, one should not rely very heavily on them.
WHO TRADES DERIVATIVES?
There are 3 types of traders in the derivatives market namely hedgers, arbitrageurs, and speculators.
i. Hedgers – They counteract market risk or a business. The risks include exposure to a commodity, an interest rate, etc.
ii. Arbitrageurs – They are intended to take advantage of the mispriced relationship between a derivative and the commodity, interest rate, etc.
iii. Speculators – They are intended to profit from market price fluctuations.
These groups meet to transact in the derivatives market. All of them have market views, divergent risks, commercial risks, etc.
MYTHS ABOUT DERIVATIVES
There are some commonly known myths surrounding Derivatives which are not true. These are:
i. Derivatives are new, high tech and developed by Wall Street rocket scientists.
ii. Derivatives are purely speculative.
iii. Only large MNCs have a purpose for using derivatives.
iv. Derivatives do not have returns.
v. Organisations engaged in risk-related activities only engage in the derivatives.
vi. The risks associated are new and unknown.
GROWTH OF EQUITY DERIVATIVE MARKET IN INDIA
From the year 2010 to 2018 there was an increase in the FO segment from 72,392.07 cr. to 6,78,588.45 cr. In the year 2012-13, the average daily turnover was 21,705.62 cr., which reduced in 2014 and 2015 by 16,444.73 cr. and 12,705.49 cr. Afterwards, it increased continuously through 2016, 2017 till 208 standing at 20,759.63 cr.
These figures show a positive trend for the derivative market and as well as for investors. It is tremendous growth and a good sign for the Indian economy.
The financial derivatives market plays a vital role in risk management and economic growth. Launch of equity derivatives market in the Indian economy has been extremely encouraging and remarkable. NSE’s derivative turnover has surpassed the equity market turnover. Thus, derivatives play a major role in the financial system.
Although the benefit and costs of derivatives remain a debatable topic, the performance of the economy and the financial system in recent years suggests that those benefits have exceeded the costs.
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