What is a derivative?
2018-07-07, By: System Administrator
Derivative is a financial instrument which is derived from another financial instrument and then traded as a product in its own right. Derivatives exist in all asset classes of the financial markets and are commonly used for hedging or speculating, so a company would buy currency forward contracts in order to hedge their risk of loss due to fluctuations in the exchange rate of two currencies. They're also one of the most brain-meltingly complicated to understand and can carry a huge amount of risk.
The Important Categories of Derivatives:
The Derivative products can be categorized into the following main types:
5. Warrants and
6. Leaps & Baskets
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 is 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.
Buying and Selling
Derivatives are traded both on exchanges and Over The Counter (OTC). Exchange trading is either through 'open outcry' on the trading floor where traders shout prices to each other and use hand signals or through electronic trading systems. Very few exchanges these days go for open outcry.
OTC trading of derivatives is a bit less transparent and a bit more risky. Privately negotiated, customized contracts are traded directly between buyer and seller which means each side is exposed to the risk of default by the other side. In reality, traders tend to use both OTC and exchange trading alongside each other to hedge their risk.
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.
Futures and Options
A future is a contract to buy or sell an asset for a specific price at a pre-determined time. If you buy future contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time.
An option gives the holder of the asset the right to have the opportunity buy or sell the underlying asset at a pre-determined price. An option can be a 'call' (the right to buy) or 'put' (the right to sell).
Who buys and sells derivatives...
The vast majority of financial institutions don't specialize in one asset class only ó they buy and sell a wide variety of instruments to manage their risk and turn a profit. These can include fund managers, hedge funds, corporate treasurers and the government and are referred to as the 'buy side' of the market. Hedge funds in particular have driven the huge increase in derivatives trading volume in recent years. A hedge fund is an investment fund used by pension companies or high net worth individuals to make profit on the money they hold.