A derivative is a financial contract whose value is linked to an underlying asset, index, rate, or benchmark; it is used for hedging risk, speculation, and arbitrage, and trades either on exchanges or over the counter depending on standardization and customization needs.
What is a derivative?
A derivative is an agreement between parties that derives its price from movements in an underlying such as equities, commodities, currencies, interest rates, or indices, and it may be traded on exchanges or bilaterally in OTC markets depending on the contract type and participants’ needs. Derivatives are typically leveraged instruments, amplifying both potential gains and losses, and are widely used to access markets, transfer risk, and express precise views on future price paths. Core contract families include forwards, futures, options, and swaps, each with distinct payoffs and market infrastructures.
Key features
- Value linkage: Contract value moves with the underlying price, benchmark, or condition, enabling targeted exposure without owning the underlying asset directly.
- Leverage: Small margins control large notional exposures, magnifying outcomes and demanding robust risk management and collateral practices.
- Hedging, speculation, arbitrage: Derivatives support risk transfer, directional bets, and exploitation of pricing discrepancies that contribute to market efficiency and price discovery.
- Market structure: Exchange-traded instruments are standardized and cleared, while OTC contracts are customized and negotiated, affecting liquidity, transparency, and counterparty risk.
OTC vs exchange-traded
- Trading venue: OTC trades are bilateral between counterparties; exchange-traded contracts transact on organized exchanges with centralized clearing.
- Standardization: OTC terms (size, maturity, settlement) are customized; exchange-traded derivatives are standardized for contract size and expiries to facilitate liquidity and interoperability.
- Counterparty risk: OTC carries bilateral credit risk with varying collateralization; cleared exchange trades benefit from a clearinghouse guarantee that mitigates default risk.
- Regulation and transparency: OTC markets are less transparent and more heterogeneous across jurisdictions; exchange-traded markets face stricter oversight and reporting that enhance transparency.
Uses of derivatives
- Hedging exposures: Offset underlying risk, for example currency, commodity, equity, or rate exposures, by taking positions that gain when the underlying risk loses value.
- Speculation: Take leveraged, directional views on price levels, ranges, or events using futures and options structures tailored to a thesis.
- Arbitrage and price discovery: Exploit cross-market mispricings and inform forward-looking prices through active trading and clearinghouse-mediated liquidity.
Misuse and failure modes
- Over-leverage and concentration: Excessive position sizing and correlated bets can create nonlinear losses under stress, as seen in historical institutional failures and trading scandals.
- Writing tail risk: Systematically selling volatility or options can earn small steady gains but incur catastrophic losses when adverse shocks materialize and liquidity evaporates.
- Weak controls: Inadequate collateralization, off-book positions, and poor governance allow losses to accumulate without timely margining, amplifying damage during market breaks.
Major types
- Forwards: Bilateral OTC contracts to buy/sell an asset at a set price on a future date, typically initiated with zero value and tailored to counterparties’ needs.
- Futures: Exchange-traded, standardized forward-like contracts with daily marking-to-market and clearinghouse intermediation for performance guarantees.
- Options: Contracts granting rights but not obligations to buy (call) or sell (put) the underlying at a strike price by or at expiry, enabling convex payoffs and hedging overlays.
- Swaps: Agreements to exchange cash flows (e.g., fixed-for-floating interest-rate payments or commodity price exposures) over time to realign risk profiles.
Long and short positions
- Long: Benefit when the underlying price rises; risk is usually limited to the premium or margin invested for options or to mark-to-market losses for futures.
- Short: Benefit when the underlying price falls; risk can be large or theoretically unbounded in certain structures (e.g., short futures or short calls without coverage).
Derivative markets in India
- Market architecture: India hosts active exchange-traded derivatives on equities, indices, currencies, and commodities under SEBI oversight, with standardized contracts and central clearing to enhance transparency and systemic safeguards.
- Retail dynamics and reforms: Rapid growth in retail options trading has coincided with widespread losses, prompting SEBI to tighten risk controls and pursue structural reforms to improve fairness, disclosures, and investor protection.
- Policy focus: Regulatory priorities include curbing excessive speculation, strengthening risk profiling and literacy, and ensuring a balanced ecosystem that supports innovation while protecting investors and market integrity.
Practical illustration
- Exporter hedge: A firm expecting USD receipts can use currency futures or forwards to lock exchange rates, stabilizing INR cash flows against adverse currency moves at settlement.
- Commodity and rates: Producers and consumers hedge input/output price risk with futures and swaps, while issuers and investors reshape interest-rate sensitivity via fixed–floating exchanges.
Closing note
Derivatives are powerful tools for risk transfer, capital efficiency, and price discovery, but their leverage, complexity, and behavioral pitfalls demand disciplined risk management, robust governance, and adherence to evolving regulatory safeguards—especially in fast-growing markets like India.
CAIIB exam Risk Management related articles in model “F” (elective paper)
