If you ask about the derivative’s meaning in the stock market, then we can say that it is a powerful financial tool which investors use to hedge risk. Financial derivatives act as securities; whose value remains dependent upon other underlying assets. Usually, stocks, currencies, commodities, bonds, market indices, and interest rates can serve as assets for derivates. The prices of these financial contracts remain dependent upon the fluctuation of the values of underlying assets.
Derivatives have the power of stabilising an economy, and if not used in the best of the interest then it can even bring it to knees through a catastrophic implosion. An infamous case of the flawed implementation of this speculative tool was the subprime mortgage crisis in the United States during 2007-2008. So, traders require advanced trading techniques and conscious use of futures contracts, forward contracts, and swaps for mitigating risks.
Though investors usually purchase derivatives through brokerages, you can also transact over-the-counter (OTC) or through an exchange. However, there is always a risk of the counterparty in OTC trading. In these unregulated dealings, if one party defaults, then it becomes challenging in earning returns. So, exchange-traded derivates are safer and convenient options.
Example of the implementation of derivative
To understand how do financial derivatives work, let’s take an example of a farmer who grows rice. Suppose he wants to sell 15 kg of rice in 3 months with a price of Rs. 50 per kg. However, uncertainties like natural disasters, inclement weather, and insufficient rainfall can act as a deterrent in his trade. So, he visits a commodities broker and enters into a contract. He vows to continually sell his product for three months at the same cost.
Now, if there is a bumper crop and the price of the grains fall to Rs 40 per kg, the broker still needs to obey the contract and pay him Rs 50 per kg for the rice. On the contrary, if the rate of the grain increases to Rs 60 per kg, then the farmer will lose Rs 10 per kg thanks to the contract.
This is the underlying concept of financial derivative.
What are the different types of financial derivatives?
1. Futures Trading
The futures contract, as the name suggests, deals with an agreement between two parties for the buying and selling of a particular asset at a future date through a standardised, exchange-regulated process. The interested parties also decide upon the pricing of the commodity (which again depends on the price movement of another instrument). Investors, as well as sellers both, can use futures trading for hedging risks. Parties signing the futures need to fulfil their commitment of going ahead with the transaction in the future, even if the pricing of assets changes considerably.
Concept of Leverage and Margin
One of the striking feature of futures is its characteristic of trading. They do not require a financial commitment equal to the value of the contract to go ahead with the deal. On the contrary, only a fractional commitment of the futures can serve the purpose. It is known as the concept of leverage.
For instance, the standard futures for gold is available at the exchange at 100 grams of the metal. So, if gold gets traded at Rs 4500 per gram, then the valuation of 100 grams would be equal to Rs 4,50,000. But you can pay a fraction of this cost and become eligible to enter a position in gold futures. This allowance is known as margin (let us consider the margin, here, is Rs 8000). So, you do not require Rs 450000 for the futures derivatives. A mere value of Rs 8000 will allow you to trade in futures of 100 grams of gold. The exchanges set the figure for the margin in futures derivatives.
The change in the price of only 1 gram of gold will result in the magnified change of the valuation of 100 grams of the metal. So, if there is a change of Rs 10 in the cost of 1 gram of gold, the value of 100-grams gold futures will move up by 1000. However, there will also be an equal increase in the margin valuation (margin will become 9000 instead of 8000). Hence, a mere rise in 0.22 per cent in the value of 1 gram of gold results in an increase of 1.25 per cent in the price of gold futures.
2. Forwards Trading
Forwards trading is similar to futures, but these transactions proceed as over-the-counter settlements instead of an exchange. They may also have customised terms and regulations, size, delivery date, and settlement process. You can settle these contracts either through cash or on delivery basis. However, there is enormous counterparty risk in these derivatives for both the buyers and sellers. Usually, grains, precious metals like gold, silver, and brass, oil, and even poultry gets traded through forwards trading.
Suppose, a farmer growing wheat expects to produce 2000 kg of grains, and he wants to sell them in four months. Now, he is concerned about the fall in the price of wheat due to a bumper crop. So, he enters into a forwards contract with a trader and plans to sell the grain at Rs 40 per kg in the coming four months. Here, the trader will settle the forwards by paying Rs 80000 at the end of the tenure through cash dealings.
Now, after four months, there are three possibilities in the outcome of this forwards trading.
- If the price of wheat remains Rs 40 per kg in the market, then the contract gets closed without any fund being owned by the farmer or the trader.
- Now if the spot price of wheat becomes Rs 50, the crop producer will owe the trader Rs 20000 (the difference between the present rate of wheat and the contracted rate).
- If the price of wheat drops to Rs 35 per kg, then the trader pays the farmer Rs 10000 and the current spot price to settle the contract (that is Rs 70000).
3. Swaps in Trading
Swaps are a unique derivative contract where business houses and financial institutions exchange liabilities from two financial portfolios. Usually, they involve the functioning of loans, bonds, or any other form of cash flows. The notional principal amount (the value which gets traded theoretically) never changes hands in swaps transactions.
Out of the two financial instruments involved in swaps, one remains fixed, and the other is variable. The variable cash flow remains based on the floating currency exchange rate or a benchmark interest, or even an index price. Similar to forwards contracts, swaps in trading take place over-the-counter instead of exchanges. Retail investors usually do not remain interested in swaps.
Different forms of swaps
There are various forms of swaps trading, like Interest rate swaps, currency swaps, debt swaps, commodity swaps, and total return swaps. Let us understand them briefly.
a. Interest Swaps
Interest rate swaps are the most popular in the market. Here, the trading parties exchange cash flows depending upon on a notional principal amount to tide over the risk associated with an interest rate. So, one leg of the future interest payments gets exchanged with another variable (which also remain based on the notional principal amount). Interest rate swaps may include the exchange of a fixed interest rate with that of a floating rate. It helps in obtaining a mutually benefitting lower interest rates for both parties involved in the swaps agreement.
b. Commodity Swaps
In commodity swaps, floating commodity prices like the rates of on-the-spot oil charges can get traded to a pre-fixed amount.
c. Currency Swaps
Currency swaps take place between the interest rates and principal amounts of debts across the currencies of various countries. During the 2010 European financial crisis, the U.S. Federal Reserve utilised aggressive swaps in trading with European financial institutions to stabilise the value of the euro (which took a downturn due to the Greek debt crisis).
d. Debt-Equity Swaps
Sometimes, public limited companies may exchange bonds for stocks of the concern. This type of debt vs equity swaps helps for refinancing their loans or realigning their fund structure.
e. Total Return Swaps
Sometimes investors may choose to swap the total return from an asset for a fixed interest rate. This type of swaps is known as total return swaps. It allows exposure to a hefty asset with a minimal cash outlay. The parties involved in this form of the swaps are termed as the total return payer and the total return receiver.
f. Credit Default Swaps (CDS)
In the credit default swaps, investors can exchange their credit risk with another party. Here a party promises to bear the principal amount and interest of a loan if another party defaults on it. However, the CDS involves an agreement and premium payment to hedge the risk of defaulting on loans. It functions similar to an insurance policy.
4. Options trading
Options trading is a flexible financial instrument where buyers decide if they wish to trade the asset or withdraw from it. So, buyers have the right to purchase an asset at a fixed price, but they don’t need to carry out the transaction mandatorily if the market value of the product falls below the agreed-upon price at a future date. This unique characteristic makes it differ from futures, where there is a compulsion to go ahead with the trading after the end of the tenure. However, investors need to pay a premium for entering into an options deal. These derivatives help in hedging risks, generating income, and even for speculation purpose. There are two types of options:
- Call Options: Here, investors can buy an asset at a stipulated price during a specific time.
- Put Options: In put options derivatives, traders can take a call regarding selling their assets at a specific rate and period.
In both the call and put options, there is an expiry date before which investors must make their decision and implement it. The call options deal with bullish buyers and bearish sellers. On the contrary, the put options work with bearish purchasers and bullish sellers.
The specific price for entering the options derivative is known as strike price (the buying or selling cost before the expiry date). You can transact in these investment instruments both through online or retail brokers. Usually, a collection of 100 shares participate in the options contracts, and investors need to pay a premium for each stock. So, in the options trading for a premium of Rs 250, traders have to invest Rs 25000 (Rs 250 X100) to purchase the contract.
To understand the difference between futures and options trading check this: Futures vs Options
Advantages of financial derivatives
Derivatives is a favourite financial instrument of many market leaders as it can play a crucial role in stabilising the economy of a country. Let us understand the advantages of financial derivatives.
Hedging Risk Exposure
Investors can use utilise derivatives for decreasing their risk exposures. As the value of derivatives depends on the rate of another asset, traders can purchase those financial instruments whose price moves in the opposite direction of the asset. In this way, they can minimise the chances of incurring a loss in the transaction.
Determination of Price of Underlying Asset
In many cases, derivatives play a crucial role in determining the rate of the underlying asset. The market value of many commodities like oil and natural gases get influenced by the spot prices of futures.
Market Efficiency
Using the derivatives judiciously, investors can replicate the payoff of assets. So, we can say that the rates of derivatives and its underlying assets remain in equilibrium through intelligent transactions of derivatives. It helps in avoiding unusual increase or decrease of indices in the market.
Access to Vast Assets
Investors can gain access to innumerable assets through derivatives, which in the standard situation, remain out of bounds. Companies can implement interest rate swaps to pay their debts at a more favourable rate than that available through direct borrowing.
Disadvantages of financial derivatives
Despite having several advantages, investors experience certain disadvantages while trading in financial derivatives. Let us explore them one-by-one.
High Risks
There is no doubt that trading in financial derivatives exposes investors to considerable risks. These financial instruments are extremely volatile. So, traders need to have in-depth knowledge about the market before dealing with derivatives.
Unpredictable Behaviour
It is challenging to forecast the price movement of derivatives. It is the reason they are considered as tools of speculation.
Counterparty Risk
There is always a counterparty risk associated with derivatives. It is especially true for forwards and swaps as they get traded over-the-counters instead of centralised exchanges. Here, the parties involved in the derivative contract do not have much knowledge about the financial health of the other. So, there is a possibility of defaulting on the agreement.
