Derivatives

We would have heard a lot about Derivatives & Derivatives Trading. But not many of us are very sure about what a Derivative is. This article is an attempt to help you learn about Derivatives.

The word 'Derivative' in Financial terms is similar to the word Derivative in Mathematics. In Maths, a Derivative refers to a value or a variable that has been derived from another variable. Similarly a Financial Derivative is something that is derived out of the market of some other market product. Hence, the Derivatives market cannot stand alone. It has to depend on a commodity or an asset from which it is derived. The price of a derivative instrument is dependent on the value of the asset from which it is derived. The underlying asset can be anything like stocks, commodities, stock indices, currencies, interest rates etc.

As you know, the financial markets come with a very high degree of risk/volatility. By using the derivative products, it is possible for us to partly or fully reduce the risk and to reduce the impact of fluctuations in the asset prices.

Let me explain how derivatives are used with a real time example...

Say, you go to an electronics shop to buy a TV. After searching around you decide on a model which costs Rs. 25000/-. The shop owner says that he would be able to deliver the TV to your house in one week if you place an order with a small initial amount today. Once the shop owner delivers the TV you are expected to pay the full amount. This is effectively a "Forward" contract where you are agreeing to the terms of delivery and a payment in a future date.

Say, I go to another electronics shop to buy a TV. After searching around I decide on a model that costs Rs. 26000/- Though I like the model I am not too sure if this is the best model for me and at the same time I am predicting the price of TV sets to come down in one week. Along with this I am also worried that if I do not buy this TV, somebody else may buy it. Thus, I talk to the salesman to put aside this TV for two weeks so that I can arrange cash and come for purchase. The salesman in return asks for a small non refundable deposit which I pay to block the TV in my name. If the price of the TV falls then I may not opt to buy the same TV but if I want I can always walk in to the shop after a few days make the payment and take the TV. This is effectively an "Options" contract, wherein I have the option of executing it at my will and wish. The shop owner took a non refundable deposit, which is to compensate for the few days that he may have to hold on to his item without selling it. Even if I do not go to buy the TV he would have made a meager profit.


The Important Categories of Derivatives:

The Derivative products can be categorized into the following main types:

1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants and
6. Leaps & Baskets

Use of Derivatives:

Hedging:

One main use of Derivatives is as a tool for transferring/reducing risk on a commodity/item. Say you are a manufacturer who uses Rice as the ingredient in your product. You would not want the price or availability of Rice to affect your production in any way. You can decide to enter into a contract with a Rice farmer to buy a specified quantity of Rice in a future date say after 3 months at a specified price. Here you are hedging to reduce your risk of availability. The farmer would also be avoiding a risk of lack of prospective buyers. By entering into agreement with you, he has reduced that risk and he has a buyer who would be buying his product on the agreed date at the agreed price. Of course there are some external factors that may cause the agreement to become null. For e.g., if due to a flood all his crops are destroyed, you cannot expect the farmer to honour the agreement. Similarly if you go bankrupt the farmer would have to find a new buyer for his products. So Derivatives can act as a tool to mitigate risk but it cannot help us avoid it altogether. Also this risk reduction will happen only between the two parties who are entering into the agreement. Any other manufacturer may end up without rice supplies or any other farmer may end up without buyers.

Types of Derivatives:

1. OTC (Over The Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.

2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.

Problems with Derivatives:

1. Possibility of Huge Losses - The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.

2. Counterparty Risk - This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.

3. Posing high risk to small/inexperienced investors - Since the Derivative markets give an opportunity for an individual to earn huge profits, its often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them...

There are a large number of Derivative categories. Covering all that in this article would make this too big to read. Hence I would be posting a new article that explains only about those categories.

Click Here to know about Derivative Categories...

Hope you found this useful. Happy Reading.