What is derivatives?

Investors will find that there are lots of opportunities to make money once they understand the concept of derivatives and its application. It is this moneymaking opportunity that has made this new instrument so popular with investors and brokers alike. SEBI allowed trading in equities-based trading on Stock Exchanges in June 2000. Thereafter, NSE and BSE allowed trading in futures and options. Stock based futures followed next and volumes in the derivatives section increased by leaps and bounds.

Derivatives are financial contracts between two parties (sometimes guaranteed by a third), where the value of the transaction depends upon the value of other factors, called 'Underlying assets', or simply assets. These are legally binding contracts to buy or sell something in future. The asset can be a share, index, interest rate, bond, rupee-dollar exchange rate, sugar, cereal, soybean or anything that is traded in the market. Informally, derivatives market has existed for long in the commodities market, mainly to hedge against price fluctuations. But now, trading volume in financial instruments is much higher than that in commodities. This is a reflection of our economy where relative GDP contribution is shifting increasingly from the secondary to the tertiary sector. As more and more companies float financial instruments in the market for investors, the derivative market has increased accordingly and given that our markets are perpetually capital hungry, prospects of the derivative market expanding even further are extremely good. Since most of these contracts are guaranteed by a third party (the Exchange), your risk against non-compliance to the contract is covered. Relatively speaking, it is much safer than trading in the equity market where no such coverage exists. In fact, responsible funds like Pension and Mutual Funds, are increasingly investing in derivatives to reap in big profits, while avoiding risks involved in such high-profit transactions.

A derivative is a very good option for the investor who wants to enter the Capital Market. It is a low-risk, high-profit transaction. Besides, the Derivatives Market can go only one way - Northwards!

Uses of derivatives:

Hedging

Hedging is a strategy designed to minimise exposure to an unwanted business risk.

Some form of risk taking is inherent to any business activity (if there were no risk, it is likely that there would be no reward). Some forms of risk are "natural" to a business, whose competitive advantage would be derived when the risk is managed well. Other forms of risk are not necessarily wanted, but cannot be avoided. For example, someone who has a shop, takes care of the risk of competition and poor or unpopular products and so on, these risks being natural in nature. The risk of their stock being destroyed by fire is unwanted/unnatural. A hedge can help lock in profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss.

Common forms of market risk are :

Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the nineteenth century, but over the last fifty years it has developed into a huge global market to hedge financial market risk.

Speculation

Speculation is the buying, holding and selling of stocks, commodities, futures, currencies, collectibles, real estate or any valuable thing to profit from fluctuations in its price as opposed to buying it for use or for income - dividends, rent etc. Speculation is one of three market roles in western financial markets, distinct from hedging and arbitrage. Speculation exists in many commodities but, when quantified, its presence is felt mostly in markets dealing in financial futures and other derivatives which involve leverage that can transform a small market movement into a huge gain or loss.

The roles of speculators in a market economy are to absorb risk and to add liquidity and capital, in the marketplace for the chance of monetary reward. For example, if there were no speculators in a certain market, say in pork bellies, the only participants in that market would be the producers (pig farmers) and consumers (pork dealers). With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies will be forced to accept an illiquid market and market prices that have a large bid-ask spread. Another example of the value of speculators is the ability of a pig farmer to sell his pork on the futures market at a known price ahead of its production.

Auctions are methods of squeezing out speculators from a transaction, but they have their own wayward effects. Sometimes, speculative purchasing can cause particular prices to rise above their "true worth" simply because the speculative purchasing is artificially increasing the demand. Speculative selling can also cause prices to fall below "true value" in a similar fashion. In some situations, price rise due to speculative purchasing and initiate further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying "value" or "worth" of the items. This is known as an economic bubble (or sometimes a speculative bubble). Such a period of increasing speculative purchasing is very often followed by one of speculative selling in which the price falls due to a crash. This is very often even more dramatic than the period of rising prices.

In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand-supply, market positions, open interests, economic fundamentals and other data to take their positions.

Arbitrage

Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals is struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur.

Arbitrage is possible when one of three conditions is not met:

See Rational pricing, particularly Arbitrage mechanics, for further discussion.

The term "arbitrage" is usually applied only to trading in money and investment instruments (such as stocks, bonds and other securities). The difference in asset prices is usually referred to as "the spread", so arbitrage is often defined as "playing the spread" in the money market.

Examples:

One real-life example of arbitrage involves the stock market in New Delhi and the futures market in Mumbai. When the price of a stock in New Delhi and its corresponding future in Mumbai are out of sync, one can buy the less expensive one and sell the more expensive one. Since the differences between the prices are likely to be small (and not last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are reasonably out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the smartest mathematicians take advantage of series of small differentials that would not be profitable if taken individually. If you can buy items at one price at a factory outlet and sell them for a higher price on an internet auction website such as Bazee.com or Rediff Shopping, you can exploit the imbalance between those two markets for those items.

Arbitrage transactions in modern securities markets involve fairly low risks. Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. There is also an unlikely counter-party risk. This could prove to be grossly hazardous because of the large quantities one must trade in order to make a profit out of small price differences. These risks become magnified when leverage or borrowed money is used.

Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.

In one form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid. The price of the takeover will more truly reflect the value of the company, generating large profits to those who bought at the current price, if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed and low risk. At some moments, when a price difference exists, the problem to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act), becomes quite unmanageable. When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information. Needless of any justifications, this practice is banned by SEBI..