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What is the Derivatives market?
Investing is one of the best ways to utilize your personal disposable income. However, there is always a range of options in terms of the investment you want to make.
The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.
Derivatives are primarily traded on regulated stock exchanges- the NSE, BSE, and National Commodities and Derivatives Exchange (NCDEX). Derivatives that are traded over the counter are standardized contracts – with features similar to those of a standard contract that is traded on a regulated stock exchange.
Financial institutions access the derivatives market because of their ability to provide cover from risks at low upfront costs. You can tap into this market should you want to keep investment-related risks (fluctuations in commodity prices or rate of interest, for that matter) in check and speculate on future trends of prices of assets.
In conclusion, a derivative market is speculative – one that shifts inherent risks to a third party. Conversely, capital markets are marked by trade risks that are clearly specified between the issuer of stocks and the equity-holder.
What are the different types of derivatives markets:-
There are four types of derivative contracts – forwards, futures, options, and swaps.
Forwards contracts are similar to futures contracts in the sense that the holder of the contract possesses not only the right but is also under the obligation to carry out the contract as agreed. However, forward contracts are over-the-counter products, which means they are not regulated and are not bound by specific trading rules and regulations.
Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date. The parties involved in a futures contract not only possess the right but also are under the obligation, to carry out the contract as agreed. The contracts are standardized, meaning they are traded on the exchange market.
These contracts are quite similar to futures and forwards. However, there is one key difference. Once you buy an options contract, you are not obligated to hold the terms of the agreement.
This means, even if you hold a contract to buy 100 shares by the expiry date, you are not required to. Options contracts are traded on the stock exchange.
Swaps are derivative contracts that involve two holders, or parties to the contract, exchanging financial obligations. Interest rate swaps are the most common swaps contracts entered into by investors. Swaps are not traded on the exchange market. They are traded over the counter, because of the need for swap contracts to be customizable to suit the needs and requirements of both parties involved.
WHO ARE THE PARTICIPANTS IN DERIVATIVES MARKETS:
Hedgers: are among the most risk-averse traders in the entire market. Their major agenda behind investing in derivatives contracts is to secure their own investment, and this is done by them assuming the opposite position to the market. By paying a slight premium, hedgers are able to transfer the risk of losses. This scenario can be better understood through this example. If you hold shares of a company, which are priced at Rs. 120, and you aim to sell these shares in 3 months; you’d ideally not want a fall in market prices to reduce the value of your investment. You also don’t want to risk missing out on a higher price in case the market value goes up. By adopting a hedging position and paying a slight premium, you can ensure that both of your concerns have been taken care of.
Speculators: As a hedger, you passed on your risk to someone who will willingly take on risks from you. But why does someone does that? There are all kinds of participants in the market.
Some might be averse to risk, while some people embrace them. This is because the basic market idea is that risk and return always go hand in hand. The higher the risk, the greater the chance of high returns. Then again, while you believe that the market will go up, there will be people who feel that it will fall. These differences in risk profile and market views distinguish hedgers from speculators. Speculators, unlike hedgers, look for opportunities to take on risks in the hope of making returns
Arbitrageurs: Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of or profiting from the price volatility of the market. Arbitrageurs make a profit from the price difference arising in an investment of a financial instrument such as bonds, stocks, derivatives, etc.
Margin traders: Many speculators trade using the payment mechanism unique to the derivative markets. This is called margin trading. When you trade in derivative products, you are not required to pay the total value of your position up front. . Instead, you are only required to deposit only a fraction of the total sum called margin. This is why margin trading results in a high leverage factor in derivative trades. With a small deposit, you are able to maintain a large outstanding position. The leverage factor is fixed; there is a limit to how much you can borrow. The speculator to buy three to five times the quantity that his capital investment would otherwise have allowed him to buy in the cash market. For this reason, the conclusion of a trade is called ‘settlement’ – you either pay this outstanding position or conduct an opposing trade that would nullify this amount.
Advantages Of Derivatives market
1-Secure Your Investment:
A derivative contract is the best way to protect yourself against an investment that you could be observing turning sour. When you trade in derivatives in the stock market, you are essentially placing money on your certainty that a certain stock will either do well or sink. A large part of derivatives trading is based on speculation and it is essential that your knowledge about the market is adequate enough before you venture into this kind of trading. As a result, if you know that the stocks you have invested in are beginning to drop in value, you could enter into a contract wherein you accurately predict the reduction in the stock value.
2-Benefit from arbitrage:
When you buy low in one market and sell high in the other market, it is called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets.
3-Be Protected From Market Volatility:
Investing in derivatives enables you to remain protected from the volatility of the market. For instance, you can buy stocks in a certain market and then enter into a derivatives contract through which you safeguard your investment, even in case you meet with a loss in the market.
4-Transfer of risk:
By far, the most important use of these derivatives is the transfer of market risk from risk-averse investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is transferred. There are a wide variety of products available and strategies that can be constructed, which allow you to pass on your risk.