All about Derivatives Market explained

[This article explains what is a Derivative- History of Derivatives – The size of the Derivatives Market – Underlying Assets – Exchange Traded and Over-the-Counter Markets – Participants in the Derivatives Market, – Functions of Derivatives – Types of Derivatives – Forward Contracts– Futures – Options ]

Definition: Derivative securities are those whose value depends on the value of another asset (called the underlying asset).

Derivatives are said to have existed even in cultures as ancient as Mesopotamia. It was said that the king had passed a decree that if there was insufficient rain and therefore insufficient crop, the lenders would have to forego their debts to the farmers. They would simply have to write it off. Thus, the farmers had just been given a put option by the king. If certain events unfolded in a certain way they had the right to simply walk out of their liabilities. The financial derivative market has been in existence in India in some form or the other for the long term. The financial derivative gained prominence in India after 1970 in some unorganized form.  The National Stock Exchange of India Limited (NSE) started trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark index — Nifty 50. The NSE introduced trading in Index Options (also based on Nifty 50) on June 4, 2001.

The gross market value of outstanding derivatives – summing positive and negative market values – increased by 13% in the second half of 2022 to reach $20.7 trillion at year-end (Source: Bank for international settlement).  According to Business Research insights, the global derivatives market size was USD 21980 million in 2020 and the market is projected to touch USD 54484.49 million by 2031 at a CAGR of 8.6% during the forecast period.

Today, equity derivatives account for a staggering 99.6% of Indian stock market volumes, totaling over $4.3 trillion per day which roughly translates into 125% of the underlying companies’ market capitalization or over 200% of the free float being traded every day. The National Stock Exchange is the world’s largest derivatives exchange for the third consecutive year in 2021 by the number of contracts traded based on the statistics maintained by the Futures Industry Association (FIA), a derivatives trade body. In the last 10 years, the cash market daily average turnover increased by 6.2 times, from ₹11,187 crore in 2011 to ₹69,644 crore in 2021.17. In India today, however, derivative volumes are more than 400x higher than that of the underlying cash equity, and 900x of delivery-based trading volumes are the highest in the world.

OTC refers to a transaction conducted directly between two parties, without the supervision of an exchange. Examples of over-the-counter stocks and securities include non-standardized derivatives, foreign currency, ADRs, and new issues. Credit Default Swap (CDS) and Credit Linked Notes (CLNs) are examples of OTC trading in credit derivatives. Exchange-traded refers to a transaction executed on a centralized exchange, with the exchange acting as a middleman.

Participants in the commodity derivatives market:

The participants in the commodity derivatives market include producers, consumers, speculators, and intermediaries. These participants play a critical role in determining the direction and stability of the commodity markets.

Producers and consumers of physical commodities are the largest participants in the Commodity Derivatives Market. They use futures and options contracts to hedge against price risks associated with their physical commodities. Producers can use these contracts to lock in a selling price for their products, while consumers can use them to lock in a buying price for their raw materials. Producers, also known as hedgers, use commodity derivatives to lock in prices for their future production. This allows them to manage the risk associated with volatile commodity prices. For example, if a farmer is growing a crop that is expected to be in high demand in the future, they can sell futures contracts to lock in a favorable price for their harvest. This protects the farmer from price changes in the market and provides them with a stable source of income.

Consumers, also known as end-users, use commodity derivatives to manage the price risk associated with purchasing commodities. For example, an airline may use fuel hedging to protect itself against fluctuations in the price of jet fuel. By entering into a futures contract, the airline can lock in a set price for fuel, which helps it budget for its future operations and manage its financial risk.

Speculators: Speculators are financial institutions and investors who trade in futures and options contracts to make a profit from price movements. They do not have a direct interest in the underlying commodities and are not using these contracts to hedge against price risks. Speculators are individuals or organizations that invest in commodity derivatives to profit from price movements. They do not have an underlying exposure to the commodity and enter into the market solely to generate returns. Speculators play a critical role in the commodity markets as they provide liquidity and help to smooth out price movements.

Intermediaries, such as banks and brokers, play a critical role in facilitating transactions in the commodity derivatives market. They help participants enter into contracts, provide market information and price quotes, and manage the settlement and delivery of contracts. Intermediaries also play a key role in reducing the risk associated with commodity derivatives by providing hedging and risk management services to their clients.

Functions of derivatives:

Derivatives markets provide for price discovery and risk transfer for securities, commodities, and currencies. Derivatives offer Speculation and Investment Opportunities.

By allowing investors to unbundle and transfer these risks, derivatives contribute to a more efficient allocation of capital, facilitate cross-border capital flows, and create more opportunities for portfolio diversification. Thus, financial derivatives are essential for the development of efficient capital markets.

The four major types of derivative contracts are options, forwards, futures, and Swaps.

Forward Contract:

A forward contract is a privately negotiated agreement between two parties to buy or sell an asset at a specified price on a future date. Under the forward contract, the buyer must pay for what has been bought and receive delivery thereof as per the contract, and for the seller to give delivery of what has been sold and receive payment for the same. It is an investment technique used to limit or offset the probability of loss from fluctuations in the prices of commodities, currencies, or securities. In other words, it is a process of hedging to reduce the risk of adverse price movements in an asset.

Futures:

Futures are exchange-traded contracts made between two parties to buy or sell a specified commodity, foreign currency, or a financial instrument at a pre-determined price on a fixed future date. In the future, the price of a commodity or a financial instrument (ex: shares of a company) is already fixed by the buyer and seller on the date of the contract, with a condition that it should be delivered to the buyer on a future date (delivery date). The future contracts are traded in the futures exchange.

Both forward contracts and future contracts are similar. The main difference between the two is that the forward contracts are privately negotiated whereas the futures contracts are standardized and traded on an exchange. Futures are traded on organized exchanges whereas the Forwards are bilateral contracts traded over the counter. The contract of futures can be reversed with any member of the Exchange, but in the forward contract, the contract can be squared off only with the same counterparty with whom the contract was originally entered into.

Options:

Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a specific period.

Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period. American options can be exercised at any time before the expiry of its option period. On the other hand, European options can only be exercised on their expiration date.

There are two types of options:

Call option: It is an option that gives the holder a right but not an obligation to buy an asset at a particular price before the date of expiry.

Put Option: It is an option that provides the holder with a right and not an obligation to sell an asset at a particular price before the date of expiry.

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