Financial Derivatives: Meaning, Nature, Users, Types, Process, Characteristics, Functions, Advantages & Disadvantages

Today in this article we are going to discuss portfolio management or financial derivatives and its Meaning, Nature, users, Types, Process, Characteristics, Functions, Advantages & Disadvantages

Financial Derivatives: Meaning, Nature, users, Types, Process, Characteristics, Functions, Advantages & Disadvantages

Meaning of financial derivatives

Derivatives are financial contracts whose value is dependent on an underlying asset or group of assets. The commonly used assets are stocks, bonds, currencies, commodities, and market indices. The value of the underlying assets keeps changing according to market conditions. The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in the future. Imagine that the market price of an equity share may go up or down. You may suffer a loss owing to a fall in the stock value. In this situation, you may enter a derivative contract either to make gains by placing an accurate bet. Or simply cushion yourself from the losses in the spot market where the stock is being traded.

Why do investors enter derivative contracts?

Apart from making profits, there are various other reasons behind the use of derivative contracts. Some of them are as follows:

·       Arbitrage advantage

Arbitrage trading involves buying a commodity or security at a low price in one market and selling it at a high price in the other market. In this way, you are benefited by the differences in prices of the commodity in the two different markets.

·       Protection against market volatility

A price fluctuation of an asset may increase your probability of losses. You can look for products in the derivatives market which will help you to shield yourself against a reduction in the price of stocks that you own. Additionally, you may buy products to safeguard against a price rise in the case of stocks that you are planning to buy.

·       Park surplus funds

Some individuals use derivatives as a means of transferring risk. However, others use it for speculation and making profits. Here, you can take advantage of the price fluctuations without actually selling the underlying shares.

Users or participants for the derivatives market

Each type of individual will have an objective to participate in the derivative market. You can divide them into the following categories based on their trading motives:

·       Hedgers

These are risk-averse traders in stock markets. They aim at derivative markets to secure their investment portfolio against the market risk and price movements. They do this by assuming an opposite position in the derivatives market. In this manner, they transfer the risk of loss to those others who are ready to take it. In return for the hedging available, they need to pay a premium to the risk-taker. Imagine that you hold 100 shares of XYZ company which are currently priced at Rs. 120. Your aim is to sell these shares after three months. However, you don’t want to make losses due to a fall in market price. At the same time, you don’t want to lose the opportunity to earn profits by selling them at a higher price in the future. In this situation, you can buy a put option by paying a nominal premium that will take care of both the above requirements.

·       Speculators

These are risk-takers of the derivative market. They want to embrace risk in order to earn profits. They have a completely opposite point of view as compared to the hedgers. This difference of opinion helps them to make huge profits if the bets turn correct. In the above example, you bought a put option to secure yourself from a fall in stock prices. Your counterparty i.e. the speculator will bet that the stock price won’t fall. If the stock prices don’t fall, then you won’t exercise your put option. Hence, the speculator keeps the premium and makes a profit.

·       Margin traders

A margin refers to the minimum amount that you need to deposit with the broker to participate in the derivative market. It is used to reflect your losses and gains on a daily basis as per market movements. It enables to get leverage in derivative trades and maintain a large outstanding position. Imagine that with a sum of Rs. 2 lakh you buy 200 shares of ABC Ltd. of Rs 1000 each in the stock market. However, in the derivative market, you can own a three times bigger position i.e. Rs 6 lakh with the same amount. A slight price change will lead to bigger gains/losses in the derivatives market as compared to the stock market.

·       Arbitrageurs

These utilize the low-risk market imperfections to make profits. They simultaneously buy low-priced securities in one market and sell them at a higher price in another market. This can happen only when the same security is quoted at different prices in different markets. Suppose an equity share is quoted at Rs 1000 in the stock market and at Rs 105 in the futures market. An arbitrageur would buy the stock at Rs 1000 in the stock market and sell it at Rs 1050 in the futures market. In this process, he/she earns a low-risk profit of Rs 50.

Types Of Derivative Contracts

The four major types of derivative contracts are options, forwards, futures, and swaps.

·       Options

Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a certain period of time. The buyer is not under any obligation to exercise the option. The option seller is known as the option writer. The specified price is known as the strike price. You can exercise American options at any time before the expiry of the option period. European options, however, can be exercised only on the date of the expiration date.

·       Futures

Futures are standardized contracts that allow the holder to buy/sell the asset at an agreed price at the specified date. The parties to the futures contract are under an obligation to perform the contract. These contracts are traded on the stock exchange. The values of futures contracts are marked to market every day. It means that the contract value is adjusted according to market movements till the expiration date.

·       Forwards

Forwards are like futures contracts wherein the holder is under an obligation to perform the contract. But forwards are unstandardized and not traded on stock exchanges. These are available over-the-counter and are not marked-to-market. These can be customized to suit the requirements of the parties to the contract.

·       Swaps

Swaps are derivative contracts wherein two parties exchange their financial obligations. The cash flows are based on a notional principal amount agreed between both parties without exchange of principal. The amount of cash flows is based on a rate of interest. One cash flow is generally fixed and the other changes on the basis of a benchmark interest rate. Interest rate swaps are the most commonly used category. Swaps are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.

Process of Trading In Derivatives Market

• You need to understand the functioning of derivatives markets before trading. The strategies applicable in derivatives are completely different from that of the stock market.
• The derivative market requires you to deposit a margin amount before starting trading. The margin amount cannot be withdrawn until the trade is settled. Moreover, you need to replenish the amount when it falls below the minimum level.
• You should have an active trading account that permits derivative trading. If you are using the services of a broker, then you can place orders online or on the phone.
• For the selection of stocks, you have to consider factors like cash in hand, the margin requirements, the price of the contract and that of the underlying shares. Make sure that everything is as per your budget.
• You can choose to stay invested till the expiry to settle the trade. In this scenario, either pay the entire outstanding amount or enter into an opposing trade.

Advantages of Derivatives

Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets:

1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination

Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

3. Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.

Disadvantages of Derivatives

Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the Global Financial Crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps led to the collapse of financial institutions and securities around the world.

1. High risk

The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.

2. Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.

3. Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.

The underlying vari­ables could be:

1. Stock prices,
2. Exchange rates, and
3. Interest rates.

These underlying variables are called cash market variables.

As an example ‘X’ consider the following financial contract:

1. There will be a gain of INR 100 if the closing price of Y share is Rs. 1008 tomorrow.
2. If the price does not move there will be no gain accruing to the investor.

The payoff that one may receive from the above contract is dependent or derived on the share price. The above financial contract is an example of a derivative contract. The payoff from such a contract is derived from the behavior of an underlying variable like a share price.

Characteristics of Derivatives:

1. Derivatives have the characteristic of Leverage or Gearing. With a small initial outlay of funds (a small percentage of the entire contract value), one can deal big volumes.
2. Pricing and trading in derivatives are complex and a thor­ough understanding of the price behavior and product structure of the underlying is an essential pre-requisite before one can venture into dealing in these products.
3. Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments.

Functions of Derivatives:

1. Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools.
2. Derivatives improve the liquidity of the underlying instru­ment. Derivatives perform an important economic function viz. price discovery. They provide better avenues for raising money. They contribute substantially to increasing the depth of the markets.

Salient Points of Derivatives:

1. Financial Derivatives are products whose values are derived from the values of the underlying assets.
2. Derivatives have the characteristics of high leverage and of being complex in their pricing and trading mechanism.
3. Derivatives enable price discovery, improve the liquidity of the underlying asset, serve as effective hedge instruments and offer better ways of raising money.
4. The main players in a financial market include hedgers, speculators, arbitrageurs and traders.
5. Hedging can be done in two ways viz. fixing a price (the linear way) and taking an insurance (non-linear or asymmetric way).

There are a number of derivative contracts. Basically they are forwards, futures and options. Forwards are definitive purchases and/or sales of a currency or commodity for a future date. Forward contracts are contracted for a particular value and should be transacted on a given date.

Forwards are useful in avoiding liquidity risk, price variations, and locking in avoiding a downside. Forward however has the limitation that the contract has to be performed in full and has attendant credit risk and market risk. Forwards are most useful in forex transactions where a spot transaction can be covered by a contrary move in the forward market.

Study Material & Notes

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