Derivatives are financial instruments whose value is derived from an underlying asset or a group of assets. These assets range from stocks, bonds, commodities, currencies, interest rates, or market indices. The derivatives market is a financial marketplace where derivative contracts are bought and sold.
Major Users of Derivatives
Financial derivatives are used for several purposes, including risk management, hedging, arbitrage between markets, and speculation. Users of derivatives include hedgers, arbitrageurs, speculators, and margin traders in the derivative market. Because derivative products offer low transaction costs and new profit patterns, they have become essential tools for hedging, speculating, and controlling financial risks.
Hedgers
A hedger is a person or company that uses derivatives to manage risk in the financial markets. Major users of financial derivatives include large business enterprises, banks, savings associations, insurance companies, institutional investors, and government organizations. Hedgers use financial instruments like futures, options, and forward contracts to offset potential losses from market volatility. They use derivatives to protect themselves from price fluctuations in underlying assets.
Arbitrageurs
An arbitrageur is an investor who earns profits by taking advantage of inefficiencies in financial markets. Arbitrage opportunities arise when an asset is priced differently between multiple markets at the same time. Such price differences are inefficiencies resulting from deficiencies in the marketplace.
Types of Arbitrage
- Merger Arbitrage: Arbitrageurs profit from price differences during mergers and acquisitions.
- Cash-Futures Arbitrage: Arbitrageurs use the futures market to profit from price differences between the spot and futures markets.
Speculators
Speculators in the derivatives market are risk-takers who trade financial instruments based on their predictions of future price movements. They are often looking for short-term profits and may use derivatives to speculate on the price of an underlying asset without owning it. Speculators can achieve these profits by buying low and selling high.
Margin Traders in the Derivatives Market
Margin trading, or “buying on margin,” refers to investors borrowing money from brokerage companies to amplify their purchasing power in the stock market. This practice enables them to buy stocks beyond their current financial capacity. By borrowing funds from a stockbroker, investors can acquire shares at a marginal price rather than the full market value. In simple terms, investors buy stocks with borrowed money and repay the loan—typically with interest—at a later date.
