Derivatives and Financial Markets6 min read

Warren Buffett -“derivatives are financial weapons of mass destruction”.

What are derivatives and why financially significant 

Financial markets are prone to high risk of uncertainty and therefore the risk of huge capital involved becomes difficult for investors, to solve the problem of partial risk, derivatives are used. Derivatives are contracts between two parties for trading financial instruments or assets that have their volatility and value. Derivatives as contracts do not serve any financial asset itself but serve the purpose of deriving the value of assets in contract from the index or prices of the underlying security. Possible instruments are equity shares, bonds, loans, mutual funds, commodities like gold, minerals, oils, real estate etc.

You must be wondering how derivatives can cure risk if they are linked to financial markets and securities?

Let us take a hypothetical example to understand what purpose exactly the derivative contract pertains to.

Suppose a company named ABC Ltd. has its shares listed on NSE at a current price of ₹100 per share. The NSE issues a contract on 1st April 2021, where it takes 500 shares of this company and lists them as derivative, suppose A took this contract at ₹50,000 which has an expiry date on 5th May 2021. A took these shares on market price as per contract. Now assuming that the contract mentioned that the selling price of these 500 shares will be fixed at ₹120 per share. This means that at any date if A sells this contract before 5th May 2021 he will be able to make a gain of ₹20 per share for sure regardless of the market price prevailing at that particular date. Hereby considering two situations.

Part1 – where at the time of selling, the market price of the share rose to ₹150 each, in this case, A will get a profit of ₹20 per share and won’t be getting the effect of the appreciation of ₹50, as the contract is termed on ₹120 per share. Whereas the buyer of this contract will be benefited as he gives ₹120 for each share and gets each share worth ₹150.

Part 2 – where at the time of selling, the market price of the share declines to ₹90 each, in this case, A will get a profit of ₹30 per share,₹20 due to contract and ₹10 due to depreciation of shares. Whereas the buyer of this contract will be at a loss as he gives ₹120 for each share and gets each share worth ₹90.

These profits and losses are not on an immediate basis and are determined by the market value of the asset when the contract is executed. These provide protection to investors, producers, and other dealers in the market from unforeseen price fluctuations by transferring price risk also called hedging.

Why derivatives were introduced?

Financial markets being highly volatile and prone to high risk needed some hedging instrument to create a cushion against the risks. Again not just seeking the risk cushion but also to make money through speculation, derivatives serve both purposes for investors. 

Types of derivatives

1. Forwards – The contracts where both parties agree on terms and get into a counter contract. Date, rate, quantity, and all other essentials are pre-decided. These types of contracts are the ones where the deal is customized by both parties, suitability of this contract is more as they are tailored and agreed upon by both parties, but the risk of default stays high as there are no intermediaries involved. The payment is done when a contract is executed on a given date therefore no pre-requirements of capital. 

1. Futures – Futures contracts are the ones where price, quantity, dates and other important aspects are pre-decided and standard for all the market participants, that is cannot be altered according to individual needs, the example stated in the above section depicts future contract. This is ensured by the presence of intermediaries like NSE or BSE or any other dealers involved. Settlement for these contracts can be commodity-based which is delivering the actual asset or either cash-based. Futures require high liquidity as they are traded on exchanges, a person holding a futures contract has no obligation to hold it till the end date, they can trade it on exchange at any time. Default risk is negligible as intermediaries ensure margin requirements and payment mechanisms. 

There are two types of futures- 

a.Index future – contracts where the underlying asset is a stock index like NIFTY, SENSEX

b.Stock future – contracts in which the underlying asset is a stock of a company 

1. Options – This contract enables the seller or buyer to not go for the final obligation of buying or selling. The contract gives options to the buyer rather than an obligation to buy the asset in the given period. The owner has the right to buy or sell a particular asset at a pre-determined price by a specified date. This right can be accessed by paying a small amount called premium to the writer of the option, that is the person bearing risk for the future if the contract is not executed. These are standard contracts, not tailored and therefore under the head of stock exchanges.

There are 5 types of options contracts –

A.Put options– provides the owner with the right to sell the asset at a certain price at a future date, generally, the price is set more than the actual price, in cases when the actual price increases more than the set price the option becomes meaningless 

B.Call options– a contract that provides the right to buy an asset at a certain price on a future date, the option is exercised only when the actual prices of an asset go up than the set price by the right holder.

C.Index options– these contracts have any trading index as an underlying asset and are dealt in certain multiple sets by formula under index futures. Generally, the closing value of the index is taken into consideration. 

D.Stock options– known as equity options, these contracts have stocks of a company as the underlying assets.

E.European and American style options-in the American option the owner can exercise buy or sell right anytime before expiry whereas, in the European option, the owner has to buy or sell on expiry date only.

1. Swaps– These contracts are private contracts between two parties to exchange cash flows in the future according to the pre-decided formula. The interest rate swaps involve swapping interest-related cash flows in the same currency. Currency swaps are the ones that compromise principal and interest both between parties in different currencies. 

 Components of the derivatives market 

1. Spot price- current market price of the underlying asset 
2. Futures price/strike price– the agreed price on which futures contract is held 
3. Contract cycle– the period over which a contract trades on the Friday following the last Thursday 
4. Expiry date- final settlement date for contracts 
5. Contract size– the lot size of an asset, Eg, the underlying asset is taken to be 500 shares of ABC ltd. , then size is 500 shares.
6. Premium – the amount against the risk of options contract paid by the owner 

Trading essentials 

1 – The derivative market requires you to deposit a margin amount before starting trading. The margin amount cannot be withdrawn until the trade is settled. Once the amount falls below requirements you would require to replenish the same level.

2 – Have a trading account that supports derivative trading as well.

3 –  choosing the contracts as well as assets would be based on market analysis and cash at hand, margin requirements and liquidity.