In today’s integrated financial marketplace, it is inevitable for a class of asset structure to outperform the others at any given point of time. However, given the role and magnitude of the importance of financial markets in driving the economy, each asset class has a certain place in the global financial markets. Derivatives are one of them.
Definition of Derivatives
A derivative is an agreement between a buyer and a seller whose value or price is derived from an underlying asset. These underlying assets could be stocks, bonds, commodities, etc.
For example: A farmer enters into an agreement with a manufacturer that he would sell certain value of wheat in 3 months. The contract has been signed by both the parties. Here, the agreed contract is the derivative. After the agreement, this value of derivative fluctuates with the change in the price of the underlying security (i.e. wheat).
Normally, the duration of the contract, i.e. the time between entering into the contract and the fulfillment or termination of the agreement, is very long (more than ten years), unlike the example which is just for 3 months.
- a unique set of financial instruments, different from other securities like stocks and bonds.
- used to protect against and manage risks which would emerge when parties enter into contracts of future uncertainties.
Uses and Users
The major reason to trade in derivative is that the markets offer opportunities to trade in future risks.
1. Eliminate Market Risks
Organizations, small or large, utilize the derivative markets to eliminate the market risks associated with a product.
For example: A manufacturing company uses the derivatives market to manage the risks emerging from the raw materials prices, exchange rates, interest rates etc. In short, markets serve as an insurance against unpredictable price movements. It reduces the volatile nature of cash flows in the company which ultimately leads to the lower capital requirement and higher capital productivity.
To trade in the derivatives market, it is not necessary to be exposed to the asset under question. In other words, derivatives are an investment tool without actually having to buy or sell the asset in a physical form. This is one of the unique differences from the stock or the bond markets.
For example: After analyzing, you forecast that price of gold will increase in the ensuing future, so you can initiate buy positions without actually having the intentions of buying physical gold in the long run. In this way, you are not exposed to the real market but you are, to the virtual market driving the prices.
3. Dual Trading Mechanism
A unique feature of the derivatives markets, unlike stock or bond markets, is you can take advantage of the falling markets by initiating sell positions without actually possessing the corresponding assets.
For example, a trader will initiate buy positions in gold if he has analyzed that the market drivers will push the prices upwards. But, if he analyzes that the prices will decline in the forthcoming days, and then he can initiate sell positions. This is known as the dual trading mechanism, i.e. a trader can take advantage of both sides of the market whether bullish or bearish.
Derivatives in Contemporary Times
Although the financial markets are immensely broad, including bonds, foreign exchange, real estate, derivatives etc., they are normally associated with the equity markets (stocks) only. In recent years, given its wide uses, the derivative markets have grown leaps and bounds. It has been an integral factor in the stability of financial market eco-system and an inevitable factor in the functioning of the real economy.
Despite the importance of derivatives’ role in the functioning of the economy, a fraction of analysts has a different perspective on their functioning which requires complete re-structuring, given the events in the financial world in recent times.
The derivatives markets have attracted attention due to the financial crisis, numerous fraud cases to name a few. Although the financial crisis in the last decade was primarily thought to be caused by the derivative products, policymakers and regulators have now slowly but surely started to infer that the derivatives markets were not the real cause of the financial crisis.
However, the consensus is that the derivative markets require stronger regulatory parameters and increased transparency to take financial markets to the next level.