Meaning, Use and Features of Derivative Market
Financial Market
Financial Market refers to the place where financial
transactions take place through the network of different participants like
borrowers, lenders, investors, etc. In
any particular economy, the financial market brings borrowers and lenders together
to place buying and selling orders with the help of brokerage and other
financial intermediaries. Thus, it is the mechanism created to facilitate the
exchange of financial assets such as bonds, stocks, foreign exchange, and
derivatives. Simply, it is the place used by businesses and
investors to raise money to grow their business and make more money.
Types of financial market
There is no hard and fast rule to classify the financial market. Some financial markets are small and some are internationally
recognized. New York Stock Exchange, Shanghai's Stock Exchange, etc.
are internationally recognized in financial markets. The money market and capital
market, foreign exchange market, derivative market, commodity market, spot
market, insurance market, etc are the classifications of the financial market.
Derivative Market
The derivative market is the type of financial market consisting of a systematic process of a present contract between at least two counterparties
i.e., buyer and seller for the trading of underlying assets of a specific quantity,
quality, price, place, and date of delivery at a certain future date. So, in the derivative
market derivative contracts are made available in order to hedge risk and
facilitate speculation to its participants. Here derivatives are not actually financial
instruments as they were developed for hedging the risk in the financial market
and commodity market.
What is the derivative?
The derivative is a contract or a piece of contract and
not a product. It
means, the derivative is a contract between any two or more than two counterparties whose value is based on the agreed underlying assets. It
is a contract derived based on any underlying assets and value of these
derivatives or contracts created by the underlying assets or price of the
underlying assets.
For example, diesel and petrol are derivatives of crude oil,
curd and cheese are the derivatives of milk. Here an increase in the price of crude oil
leads to an increase in the price of diesel and petrol and an increase in the price of milk
leads to an increase in the price of cheese and curd also. So, derivatives are derived
types of things and whose value is based on their underlying assets.
Meaning of Derivative Market |
The underlying assets may be financial assets like
stock, bonds, markets rates, currencies, interest rates, etc. and non-financial
or commodities like crude oil, cotton, wheat, gold, silver, etc. In the case of
financial underlying assets, the created derivatives are called financial
derivatives and, the derivatives created on the basis of commodity
types of underlying assets are called commodity derivatives.
Role of derivatives
It has three basic uses
- Hedging Risks
- Speculation and expectations of profit
- Use for Arbitrageurs
Hedging the Risk
The market is not in the
control of the hand of the individuals and no can predict market perfectly. The future is uncertain and here we talk about how derivatives can hedge the possible
risk of the investors. Thus, hedging is the process of minimizing risk.
It
means, suppose you have invested your money in the stock market for the long
term perspective and you have expected that the price of the stock in which
investment has made will increase and grow continuedly and you could earn good
returns.
However, the stock market
may not always show a good indication of growth and may not follow the pattern
you have expected before investment. There
may be times of decline. One thing is there, now if you expect that the market
price of the stock that you have invested will decrease instead of increase then
you can sell your investment at an immediate price and rid of it.
But what
happened if you have invested for a long-term purpose and you are now expecting the price is to decrease? So now the situation is, you have invested
your money into the stock market with the expectation of stock price will grow
continued but the time has come in such a way that stock price is expected to
decrease. And you don’t want to sell the stock and still, you would want to
avoid the loss that can arise due to the expected fall in stock price. What
could be done?
Risk Hedging With Derivative Contract |
Let’s look at how exactly
the expected loss could be eliminated:
Now the investor can enter into the future contract of five months in the derivative market
with a short position (in finance, being short in an asset means
investing in such a way that investor will profit if the value of such asset
falls).
In a declining market, the investor should always take a short position in the future contract as to able to
avoid the loss of holding the stock. (You can find the detailed explanation of this case is in the post
related to the futures contract and for such click HERE)
Speculation with
expectation of profit
Speculators
are also engaged in the derivative market with an expectation of making
profit. They entered into a derivative market not with the objective of
minimizing the risk rather with an objective of maximizing the profit through
speculation.
Speculators always look for the opportunity to profit and when they feel there would any possible profit they
entered into a derivative contract. (Detail explanation is in the example
section at last)
Use for Arbitrageurs
Arbitrageurs are low risk-takers and always looking for market imperfections. And from the exploitation
of these imperfections and indifference, they take advantage. Arbitrageurs conduct simultaneous contracts in
different two markets of similar goods or security. In one market they do a contract of purchase and in another market, they do a contract of sale.
This is only possible when the same commodity or
security is quoted at different prices in two different markets.
These all the uses can be
explained with the help of the following example:
So, Participants of Derivative Markets are;
Participant |
Existing Risk |
Objective |
Basis |
Hedgers |
There is an existing risk |
To hedge risk |
Derivative contracts |
Speculators |
No existing risk |
To earn profit |
Speculation of prices |
Arbitrageur |
No existing risk |
To earn profit |
Mispricing of the same
product/underlying assets in two different markets |
ReplyDeleteThanks for providing useful blog
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