Derivative market and types

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A derivative is derived from an underlying asset or group of assets. Underlying assets can be equities, interest rates, currencies and commodities It is a financial security.

Derivatives is used as a risk management tool that allows an investor to transfer the risks attached with the underlying asset to the party who is willing to take it. There can be a number of risks such as market risks, credit risk and liquidity risk.

There are 4 types of derivative market

Forward

It is a contract between 2 parties, where settlement takes place on a specific date in future at an agreed priced on current date.

Futures

It is an exchange traded contract to buy or sell financial instruments or physical commodities for future delivery at an agreed price.

Options

Options are traded through buying puts or calls. When you buy a put you are expecting the price of the underlying to fall below the strike price of the option before the option expires. A call options works the same way, except when you buy a call you are expecting the price of the underlying to rise.

Example: A stock priced at Rs 100, but you believe it will fall to Rs 95, so buy put options, by paying a fixed amount (Premium). If a stock goes down then you can sell it for more than you paid for it (premium). But if it falls you will only lose the premium amount. In call it is vice versa.

Swaps

A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to.

There are 3 types of investors in derivative market

Arbitrageurs:

This investor buys an asset at a cheaper rate from one market and sells it at a higher price in another market, here the investor is taking the minimum risk. This price gap is very brief and it narrows down quickly, and the arbitrageurs might lose the opportunity.

Example: If a share Xyz is trading @ Rs 100 per share in cash market, and Rs 102 in future market. Arbitrageurs would buy xyz share @ Rs.100 from cash market and sell @ Rs.102 in future market, hence making a Rs.2 profit per share.

Hedgers:

Hedging is minimizing the risk or loss. In market, an investor who protects his investment from unfavourable price movements is called a hedger. Hedger tries to limit the risk by buying put options by paying a fixed amount known as premiums.

Example: An investor has a portfolio of Rs. 5,00,000, to protect his portfolio from volatility, he can short index futures to make his portfolio beta neutral or he can buy Put option by paying a fixed cost known as premiums.

Speculator:

They are the risk taker, they take high risk expecting higher gains in short-term. They buy stock with an expectation of price rise and sell them at a high price level. This situation can make a high gains for an investor though it also has very high risk of losing your money.

Example: If a speculator feels that the price of ABC company is likely to fall in a few days due to some upcoming market developments, he would short sell the ABC company’s share in a derivatives market. If the stock price falls as expected, then he would make a good profit depending on his holding. However, if stock prices go up against the expectation, then his loss would be equivalent.

Derivative market require a different amount of capital for different market, and different traders select their market according to their need. Futures are very popular with day traders–day traders only trade within the day and don’t hold positions overnight. Options are more popular among swing


Also published on Medium.