The derivative market was introduced in India in the year 2000 and since then it’s gaining great significance like its counterpart abroad.
Just like shares, Derivatives are also traded in stock exchanges.
Derivatives are a type of security, whose value is derived from an underlying asset.
These underlying assets can be stocks, bonds, commodities or currency.
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The popularity of derivative can easily be understood by daily turnover in the derivative segment on the exchange, which is much higher than turnover in the cash segment on the same exchange.
From the below graph we can see how the Derivatives market showed continuous growth in the past years:
1. What is a Derivative Market?
Derivatives can either be exchange-traded or traded over the counter (OTC).
Exchange refers to the formally established stock exchange wherein securities are traded and they have a defined set of rules for the participants.
Whereas OTC is a dealer oriented market of securities, which is an unorganized market where trading happens by way of phone, emails, etc.
Derivative traded on the exchange are standardized and regulated.
On the other hand, OTC derivative constitutes a greater proportion of derivatives contracts, but it carries higher counterparty risk and is unregulated.
These financial instruments help in making a profit by simply betting on the future value of the underlying asset.
Hence the name derivative as they derive the value from the underlying asset
For instance, Derivative contracts are used by the wheat farmers and baker in order to hedge their risk.
The farmer fears that any fall in price would impact his income
Hence enters the contract to lock in the acceptable price for the given commodity.
On the other hand, the baker in order to hedge his risk on the upside enters the contract so that he does not suffer losses with a rise in price.
2. Use of Derivatives:
Derivative contracts like futures and options trade freely on exchanges and can be employed to satisfy a variety of needs which includes the following-
a) Hedge your securities
The derivative contracts can be used to hedge your securities from price fluctuations.
The shares which you possess can be protected on the downside by entering into a derivative contract.
Moreover, it also protects you from the rise in share price which you plan to purchase.
b) Transfer of risk
This is the most important use of derivative which helps in transferring risk from risk-averse people to a risk-seeking investor.
The risk-seeking investor can enter into a risky contrarian trades to gain short-term profits.
While the risk-averse investor can enhance the safety of their position by entering into a derivative contract.
c) Benefit from arbitrage opportunities
Arbitrage trading simply means buying low in one market and selling high in another market.
So with the help of derivative contracts, you can take advantage of price differences in two markets.
Thus it helps in creating market efficiency.
3. Difference between cash and derivative market:
In cash market, we can purchase even one share whereas in case of futures and options the minimum lots are fixed
In cash market tangible assets are traded whereas in derivatives contracts based on tangible or intangible assets are traded.
Cash market is used for investment. Derivatives are used for hedging, arbitrage or speculation.
In case of cash market, a customer must open a trading and demat account whereas for futures a customer must open a future trading account with a derivative broker.
In case of cash market, the entire amount is put upfront whereas in case of futures only the margin money needs to be put up.
When an individual buys shares, he becomes part owner of the company whereas the same does not happen in case of a futures contract.
In case of cash market, the owner of shares is entitled to the dividends whereas the derivative holder is not entitled to dividends.
4. Participants in the derivative market
The participants in the derivative markets can be segregated into three categories namely-
These are traders who wish to protect themselves from the risk or uncertainty involved in price movement.
They try to hedge their position by entering into an exact opposite trade and pass the risk to those who are interested to bear the same.
By doing this they try to get rid of the uncertainty associated with the price.
For example, you have 1000 shares of XYZ Ltd. and the CMP is Rs 50.
You are planning to hold the stocks for 6-9 months and you expect a good upside.
However, in the short term, you feel that the stock might see a correction but you do not want to liquidate your position today as you are expecting a good upside in the near term.
For example, you can enter into an options contract (a part of the derivative strategy) by paying a small price or premium and reduce your losses.
Moreover, it would help you benefit whether or not the price falls. This is how you can hedge your risk and transfer it to someone who is willing to take the risk.
They are extremely high-risk seekers who anticipate future price movement in the hope of making large and quick gains.
The motive here is to take maximum advantage of the price fluctuations.
They play a very key role in the market by absorbing excess risk and also provide much-needed liquidity in the market when normal investors don’t participate.
Arbitrage is a low-risk trade which involves buying of securities in one market and simultaneous selling it in another market.
This happens when same securities are trading at different prices in two different markets.
For instance, say the cash market price of a share is Rs 100 and it is trading at Rs 110 per share on the futures market.
An arbitrageur observes the same and bought 50 shares @ Rs 100 per share in the cash market and simultaneously sells 50 shares @Rs 110 per share, thus gaining Rs 10 per share.
5. Types of derivative contracts
There are four types of derivative contracts which include forwards, futures, options, and swaps.
Since swaps are complex instruments which we cannot trade in the stock market, so we’ll focus on the first three.
a) Forward contracts
They are customized contractual agreements between two parties where they agree to trade a particular asset at an agreed upon price and at a particular time in future.
These contracts are not traded on an exchange but privately traded over the counter.
b) Futures contracts
These are standardized version of the forward contract which takes place between two parties where they agree to trade a particular contract at a specified time and at an agreed upon price.
These contracts are traded on the exchange.
It is an agreement between a buyer and a seller which gives the buyer the right but not the obligation to buy or sell a particular asset at a later date at an agreed-upon price.
6. Difference between forward and futures contract
The main difference between forward and future contract are:
Forward contracts are traded on personal basis while future contracts are traded in a competitive arena.
Forward contracts are traded over the counter whereas futures are exchange traded.
Forward contracts settlement takes place on the date agreed upon between the parties whereas futures contracts settlements are made daily.
Cost of forward contracts is based on bid- ask spread whereas futures contract have brokerage fees for buy and sell order.
In case of forwards, they are not subject to marking to market. On the other hand, futures are marked to market.
Margins are not required in case of forward market whereas in futures margin is required
In a forward contract, credit risk is borne by each party whereas in case of futures the transaction is a 2 way transaction, hence both the parties need not bother about the risk
7. Types of Futures
Depending on the underlying asset, there are different types of future contract available for trading.
They are: –
a) Individual stock futures-
They are contracts between 2 investors.
The buyer promises to pay a specified price for say 500 shares of a single stock at a predetermined future point.
The seller promises to deliver the stock at a specified price on the specified future date.
b) Stock index futures
The underlying asset is the stock index. Stock index futures are more useful when one is speculating on the general direction of the market rather than the direction of an individual stock.
It can be used for hedging a portfolio of shares.
c) Commodity futures-
Here the underlying asset is a commodity like gold, silver, nickel, crude oil etc.
In India commodity futures are traded on 2 exchanges namely MCX ie Multi Commodity Exchange and NCDEX ie National Commodities and Derivatives Exchange.
The following are some of the examples of commodities – pulses, cereals, fibre, oil and seeds, energy, metals and bullion.
d) Currency futures-
These are exchange traded futures contract that specify the price in one currency at which another currency can be bought or sold at a future date.
These are legally binding and the parties that hold the contracts on the expiry date must deliver the currency amount on the specified date at the specified price.
e) Interest rate futures-
The underlying asset in this case is the debt obligation which move according to the changes in the interest rates.
8. Types of Margin requirements
There are basically three types of margin in derivative trading.
These are Initial margin, Maintenance margin, and Variation margin-
a) Initial margin
It is the initial cash which you must deposit in your account before you start trading.
This is required to ensure that the parties honor their obligation and provides a cushion to the losses in the trade.
In simple words, it is like the down payment for the delivery of the contract.
b) Maintenance Margin
It is a cash balance which a trader must bring to maintain the account as it may change due to price fluctuations.
Maintenance margin is a certain portion of the initial margin for a position.
If the margin balance in the account goes below such margin, the trader is asked to deposit required funds or collateral to bring it back to the initial margin requirement.
This is known as a margin call.
c) Variation Margin
As soon the margin falls below the maintenance margin, you need to deposit cash or collateral to bring the account back to the initial margin.
9. Key Takeaways:
A derivative is a financial contract which derives its value from one or more underlying assets.
Derivatives can be forward, future contract, options and swap.
Most derivatives are used as a hedging tool or to speculate changes in the prices of an underlying asset
Derivatives are highly leveraged instruments which increases their potential risk and rewards.
There are basically three types of margin in derivative trading which are Initial margin, Maintenance margin, and Variation margin.