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http://www.managementparadise.com/article/5268/derivatives-a-brief-discussion
Category: Finance / Derivatives
Published on Wednesday 2 October, 2013

Derivatives: A brief discussion
By Adri Mitra (M.Phil, M.Com, PGDM)


Concepts of Derivative
(1) A derivative is an instrument whose value is derived
from the value of one or more underlying, which can be
commodities, precious metals, currency, bonds, stocks,
stocks indices, etc. Four most common examples of
derivative instruments are Forwards, Futures, Options and
Swaps.
(2) Derivative is a financial contract whose value is based
on, or "derived" from, a traditional security (such as
a stock or bond), an asset (such as a commodity), or
a market index. A derivative instrument is a contract
between two parties that specifies conditions (especially
the dates, resulting values of the underlying variables, and
notional amounts) under which payments are to be made
between the parties.
(3) In finance, Derivative means, the contracts whose
value is derived from another asset, which can include
stocks, bonds, currencies, interest rates, commodities, and
related indexes. Purchasers of derivatives are essentially
wagering on the future performance of that asset.
Derivatives include such widely accepted products
as futures and options.
(4) A derivative is a financial instrument whose value is
dependent upon the change in the value of an underlying
asset - such as a commodity, equity or bond or upon an
event such as a change in interest rates, foreign currency
exchange rates, inflation rates or the weather. The risk
associated with the change in the value of the underlying
asset is transferred between the parties to the derivative
contract.
What are the different types of Derivatives?
(1) Futures contracts
(2) Forward contracts
(3) Options
(4) Swaps.
What are the major asset classes of Derivatives?
(1) Interest rate derivatives
(2) FX derivatives
(3) Commodity derivatives (including agricultural, energy,
precious metals and other commodities)
(4) Credit derivatives (including credit default swaps)
(5) Equity derivatives.
What are the Contracts related to Derivatives?
(1) Forward Contracts
A forward contract is a customized contract between two
parties, where settlement takes place on a specific date in
future at a price agreed today. The main features of
forward contracts are
-They are bilateral contracts and hence exposed to
counter-party risk.
-Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and the asset type
and quality.
-The contract price is generally not available in public
domain.
-The contract has to be settled by delivery of the asset on
expiration date.
-In case the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which being in
a monopoly situation can command the price it wants.
(2) Futures Contracts
Futures are exchange-traded contracts to sell or buy
financial instruments or physical commodities for a future
delivery at an agreed price. There is an agreement to buy
or sell a specified quantity of financial instrument
commodity in a designated future month at a price agreed
upon by the buyer and seller. To make trading possible,
BSE specifies certain standardized features of the contract.
Why Derivatives are used by the investors?
Derivatives are used by investors for the following reasons:
(1) To provide leverage or gearing, such that a small
movement in the underlying value can cause a large
difference in the value of the derivative;
(2) To speculate and make a profit if the value of the
underlying asset moves the way they expect (e.g., moves
in a given direction, stays in or out of a specified range,
reaches a certain level);
(3) To hedge or mitigate risk in the underlying, by entering
into a derivative contract whose value moves in the
opposite direction to their underlying position and cancels
part or all of it out;
(4) To obtain exposure to the underlying where it is not
possible to trade in the underlying (e.g., weather
derivatives);
(5) To create option ability where the value of the
derivative is linked to a specific condition or event (e.g. the
underlying reaching a specific price level).
(6) Derivatives can be used for speculation ("bets") or
to hedge ("insurance"). For example, a speculator may
sell deep in-the-money naked calls on a stock, expecting
the stock price to plummet, but exposing itself to
potentially unlimited losses. Very commonly, companies
buy currency forwards in order to limit losses due to
fluctuations in the exchange rate of two currencies

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What are the Common examples of derivatives used

in everyday business?
(1) A farmer entering into a wheat forward contract to
lock in the price at which he sells his crop at harvest time;
(2) A manufacturer entering into an FX forward to lock the
cost in US Dollars of machinery that it purchases from a
foreign supplier;
(3) A computer chip company entering into a gold forward
contract to fix the price it will pay for the gold it uses in its
microprocessors;
(4) A commercial real estate developer entering into an
interest rate swap to lock the rate on the floating rate debt
it uses to finance the construction of a new building.
Which types of derivatives are most commonly used
by end users for risk management?
(1) Interest rate derivatives,
(2) FX forwards and
(3) Commodity forwards.
The interest rate swap and the FX forward are, by far, the
two most common products used by non-financial end
users.
Where are derivatives traded?
Some derivatives are traded on organized and regulated
exchanges as exchange-traded derivatives) and some are
traded privately off exchange as over-the-counter or as
OTC derivatives).
Who are the different participants in the derivatives
market?
(1) Dealers: A dealer is a firm that stands ready to take
either side of a derivative transaction if so demanded by its
customers. It is the dealer's willingness and ability to buy
or sell a derivative on demand that creates the market for
the derivative (i.e., market making). Dealers are
sometimes referred to collectively as the sell side.
If there were no dealers, customers would have to find
another party willing to take the other side of their
transaction. An example that might prove useful in
demonstrating the concept of dealing and market making
is that of a grocer. Without the grocer, a consumer would
have to go directly to the baker and the butcher to buy
bread and meat. The grocer is not in the business of
baking or butchering; it buys from the baker and butcher
and then sells to consumers for a profit it makes a market
in food products.
(2) End Users: Technically speaking, any non-dealer is an
end user, including speculators and hedgers; however,
throughout the policy debate over the regulation of OTC
derivatives, the term end user has come to mean
companies that use derivatives to hedge business risk. End
users are sometimes referred to collectively as the buy
side.
The end-user category can be broken down further into
two sub-categories: hedgers and speculators.
(2.1) Hedgers are businesses that use derivatives to
mitigate, reduce or eliminate risks associated with their
businesses. Hedgers use derivatives to gain predictability,
not to profit. Indeed, a firm that is hedging has decided to
forego a potential windfall, if the underlying moves in a
beneficial direction, for the certainty of fixing the price of
the underlying. With a hedge, if the underlying is down,
the derivative is up; if the underlying is up, the derivative
is down. Virtually all types of companies, across all sizes
and industry sectors, use derivatives to hedge risks
associated with their businesses.
(2.2) Speculators use derivatives to take on risk in the
hopes of making a profit. Examples of firms that frequently
use derivatives for speculation include hedge funds, asset
managers and proprietary trading firms.
What are the common Economic functions of the
derivative market?
Some of the salient common economic functions of the
derivative market include:
(1) Prices in a structured derivative market not only
replicate the discernment of the market participants about
the future but also lead the prices of underlying to the
professed future level. On the expiration of the derivative
contract, the prices of derivatives congregate with the
prices of the underlying. Therefore, derivatives are
essential tools to determine both current and future prices.
(2) The derivatives market relocates risk from the people
who prefer risk aversion to the people who have an
appetite for risk.
(3) The intrinsic nature of derivatives market associates
them to the underlying Spot market. Due to derivatives
there is a considerable increase in trade volumes of the
underlying Spot market. The dominant factor behind such
an escalation is increased participation by additional
players who would not have otherwise participated due to
absence of any procedure to transfer risk.
(4) As supervision, reconnaissance of the activities of
various participants becomes tremendously difficult in
assorted markets; the establishment of an organized form
of market becomes all the more imperative. Therefore, in
the presence of an organized derivatives
market, speculation can be controlled, resulting in a more
meticulous environment.
(5) Third parties can use publicly available derivative prices
as educated predictions of uncertain future outcomes, for
example, the likelihood that a corporation will default on its
debts.
In a nutshell, there is a substantial increase in savings and
investment in the long run due to augmented activities by
derivative Market participant.