What Are Derivatives ?

 In Stock Market For Beginners

What Are Derivatives ?

In the world of finance derivative is a type of financial product whose value is linked to the underlying assets. Underlying assets meaning in a derivative or warrant is that it is a type of security, property, or other assets that influences the value of the derivative or warrant. For example, in an option giving one the right to buy stock in Johnson and Johnson, the underlying asset is the stock in Johnson and Johnson. The derivative is a bond between two parties and its value is derived from the fluctuations in the underlying assets.

Types of Derivatives

Forwards Contracts

This type of derivative is a custom-made contract between two parties in which the settlement between the parties takes place in the future on any decided date. The price is decided beforehand and at the same price, the deal is made in the future. So when there are such future settlements between two parties to buy or sell an underlying asset it is called a forward contract. As mentioned earlier the contract is customized, hence the size of the contract is dependent on the term of the contract. These types of derivatives can be self-regulated and collateral is not required.

Future Contracts

Futures contract is quite self-explanatory and similar to forward contracts it is a deal made to buy or sell an underlying asset at a specified price on a future date. In the futures contract, there is no need for the parties to meet each other to make the agreement. The counterparty risk factor in future contracts is low as the settlement is standardized. As it follows a standardized contract, the regulation is taken care of by the stock exchange, and the size is also fixed. To sum up, the future contracts being standardized has the preset size, preset expiry date, and preset format.

Options Contracts

The features of options contracts are quite dissimilar as compared to the above two types of derivatives. In the other types of contracts, there is no mandate to discharge the contract on the specified or decided date. In this type, the parties can opt to buy or sell the asset but are not obliged to do so. The option contract is also divided further into two types namely- call and put. When the buyer party has the right to purchase the asset at a predetermined price when the initial deal was made it is called a call option. Whereas in the put option the buyer party can buy the asset but not obliged to sell the asset at a pre-decided price.

Swap Contracts

Out of all the above various types of derivatives contracts mentioned above, the swap contracts are the most complicated. These contracts are made between the two parties privately. The parties decide a predetermined formula and exchange their cash flow according to the formula in the future. The risk parameter in swap contracts is high as the underlying security is the interest rate or currency. As these both are quite volatile the risk factor is high. However, this type of derivatives protects the buyer and seller from various risks. These contracts are not regulated by any exchanges and traded via middlemen.

Equities are generally instruments to make investments while derivatives means the instruments that are used for speculation or hedging purposes. Now that you know what is derivative let us discuss who and why buy the derivative instruments.

Who Should Trade in Derivatives?

Hedgers

The investors who are known to hedge a risk are called as hedgers. So the process of hedging is nothing but minimizing risk. Hedging involves tackling different parameters resultant from current market conditions which impact the risk factor. This type of investor will attempt to decrease or remove price risk conditions in conditions of price volatility in the market.
Let us understand with an example, suppose an investor buys 1000 shares in an XYZ company but expects a long position against market trends particularly when the market is volatile and highly unpredictable. To avoid exposure to unfavorable events when the market is volatile he should also take a short position of the equivalent amount of the same company futures to form a hedge.

Speculators

Speculators are the investors who scrutinize the price factor and after proper evaluation, they invest when the price factor is in favor of maximum gains. The only mantra is to make maximum profits through derivative investments. Unlike hedgers, they don’t fear taking higher risks which ensures maximum returns and sometimes huge loss during unfortunate markets conditions. The speculators must identify the future market trends as precise and it could get in order to find the right position in the market. Speculators expect to make maximum profits with short-term investments. To achieve this, they recognize future forecasts basis the fundamental and technical analysis done by them. You will find the portfolio of a speculator fully diversified which has a high-risk factor but capabilities of generating higher returns.

Arbitrageurs

Arbitrageurs function a bit differently and in a swift manner and has the proficiencies of making instant decisions to generate better gains with minimal risk scenario. They are the investors who work towards improving liquidity in the market by making most of the arbitrage opportunities available for a specific period. When such opportunities are available they buy or sell the derivative instruments immediately. They only trade when there is a chance to earn money when the risk profile is low as well. Arbitrageurs create the best possible outcome when they find any time-bound price differences for a particular share.

Now if you are familiar with what is derivative let us discuss the advantages and disadvantages of derivatives.

Advantages of Derivatives

Hedging risk exposure

As per the meaning of derivatives mentioned above the value of the derivatives is dependent on the value of the underlying asset, so the contracts are made with a view to hedge risk parameter. To hedge risk, the investor makes purchases derivative contract whose value moves in the opposite direction to the value of an asset.

Identifying the price of the underlying asset

Derivatives help in identifying the price valuation of the underlying asset.

Market efficiency

It is considered that derivatives increase the efficiency of financial markets. With the help of derivative contracts, one can replicate the payoff of the assets.

Disadvantages of Derivatives

High risk

The derivatives can be highly volatile which can incur significant losses. Hence the risk factor in derivatives is largely high.

Speculation oriented

Derivative are unpredictable and highly dependent on speculations. This tool of speculation can bring huge losses if the speculation is unreasonable.

To conclude, we have understood the types of derivatives with examples and how they are the best hedging instruments. With these instruments, traders can predict the future after a better analysis of price movements eventually giving good profits.

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