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:

Example of Participants of Derivative Marke

Example of Hedging Risks  

In the above example, there is a village with certain numbers of farmers producing wheat. The current market price of wheat is Rs. 50 per kg and they can grow their wheat only after three months and they think the price of wheat may fall in the coming days so they have the existing risk of fall in price. In the same village there is a bakery who uses wheat for making its production and here bakery is expecting that price of wheat in the market in the coming days could increase from Rs. 50 per kg.  

So, the bakery has also the existing risk of a rise in the price of wheat. So, they both farmers and bakers entered into a contract (Derivative or forward contract) (for farmers contract to sell @50 after three months and for baker the contract to buy @Rs. 50 after three months). Here the created contract is called derivative, the underlying asset is wheat, and participants are known as hedgers as they both want to minimize their risk. Therefore, one of the important uses of the derivative is to hedge the risk. Here hedgers do not have any possibility of loss from the derivative contract.

Example of Speculation and Profits

Again, there is one person who is seeing the contractual relationship between farmers and bakers. He thinks that the price of wheat will increase in the future and he is speculating that after three months the price is going to more than Rs. 50 per kg. So, he went o farmers and told them to make contact with him also for Rs.50 per kg after three months and as a result, he makes a contract to buy and farmers make a contract to sell. 

Here this individual is called a speculator and who does not have any existing risk exposure. The speculators always play with derivatives for earning profit and seeking the opportunities of profit on the basis of price speculations. Here the speculator speculates that the price will more than Rs. 50 per kg and he could purchase wheat at the agreed price of Rs.50 and can sell at a higher price and earn a profit. He has the possibility of loss.

Example of Arbitrageurs and Profit

There is another person who keeps looking at different places and markets to earn a profit. In his place suppose there are some farmers producing wheat and the current market price is Rs. 60 per kg and who are expecting the risk of falling price like the farmers of the earlier village. There is also a bakery having the existing risk of an increase in the price of wheat from the current price of Rs. 60 per kg and as a result, they both are also entered into the forward contract at Rs. 60 for three months. 

That person went to the previous village and made a contract with the farmer to sell wheat to him at Rs. 50 per kg after three months and farmers also agreed to do a contract with him too. Here he has made one contract with the farmers of the earlier village to buy the underlying assets at Rs.50 for three months and farmers have made a contract to sell wheat. 

He simultaneously made a contract with the bakery of his own village as he requested the bakery to provide wheat at Rs. 60 after months. So, he formed a contract to sell to the bakery @ 60 per kg after three months and he made a contract to buy with the farmers of earlier village @50 after three months. This person is known as Arbitrageur who does not have any existing exposure and he entered into two contracts to earn a profit on the basis of mispricing of the same product in two different places or markets. Arbitrageur does not have any possibility of loss. 

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