What is derivative market?
A derivative market is a market where financial instruments that derive their value from an underlying asset or benchmark are traded. Derivatives can be used for various purposes, such as hedging, speculation, arbitrage, or accessing new markets. In this blog post, we will explore the definition, types, participants, and benefits of derivative markets.
Definition of derivative market
A derivative is a contract between two or more parties that specifies the conditions under which payments or deliveries are made based on the performance or value of an underlying asset or benchmark. The underlying asset can be anything, such as stocks, bonds, commodities, currencies, interest rates, or market indexes. The benchmark can be a reference rate, such as LIBOR or EURIBOR, or a mathematical formula, such as a volatility index.
A derivative market is a financial platform that facilitates trading all financial instruments that fall within the derivatives category and whose values are derived from underlying assets. The derivatives market includes both exchange-traded derivatives and over-the-counter derivatives.
Exchange-traded derivatives are standardized contracts that are traded on organized and regulated exchanges, such as the Chicago Mercantile Exchange (CME) or the National Stock Exchange of India (NSE). Exchange-traded derivatives offer transparency, liquidity, and lower counterparty risk, as the exchange acts as a clearinghouse and guarantees the settlement of the contracts.
Over-the-counter derivatives are customized contracts that are traded directly between two parties, without intermediation by an exchange. Over-the-counter derivatives offer flexibility, confidentiality, and tailor-made solutions, as the parties can negotiate the terms and conditions of the contracts according to their needs and preferences. However, over-the-counter derivatives also entail higher counterparty risk, operational risk, and regulatory risk, as there is no central authority to monitor or enforce the contracts.
Types of derivative market
There are four main types of derivative contracts: options, futures, forwards, and swaps. Each type has its own features and applications.
Options are contracts that give the buyer (holder) the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a specific date (expiration date). The seller (writer) of the option receives a premium from the buyer in exchange for taking on the obligation to deliver or receive the underlying asset if the option is exercised. Options can be classified into call options and put options. A call option gives the buyer the right to buy the underlying asset, while a put option gives the buyer the right to sell the underlying asset.
Futures are contracts that obligate the buyer and seller to buy or sell an underlying asset at a predetermined price on a specific date in the future. Futures contracts are standardized and traded on exchanges. Futures contracts can be settled by physical delivery of the underlying asset or by cash settlement based on the difference between the contract price and the market price at maturity.
Forwards are contracts that obligate the buyer and seller to buy or sell an underlying asset at a predetermined price on a specific date in the future. Forwards contracts are customized and traded over-the-counter. Forwards contracts are usually settled by physical delivery of the underlying asset.
Swaps are contracts that involve two parties exchanging cash flows based on different reference rates or prices of an underlying asset or benchmark. Swaps can be used to hedge against interest rate risk, currency risk, commodity risk, or credit risk. The most common type of swap is an interest rate swap, which involves exchanging fixed-rate payments for floating-rate payments based on a notional principal amount.
Participants of derivative market
The participants of derivative markets can be categorized into four groups: hedgers, speculators, arbitrageurs, and margin traders.
Hedgers are participants who use derivatives to reduce or eliminate their exposure to various risks associated with their underlying assets or liabilities. For example, a farmer who grows wheat can use futures contracts to lock in a price for his crop and protect himself from unfavorable price movements in the spot market. A manufacturer who imports raw materials from abroad can use currency swaps to hedge against exchange rate fluctuations.
Speculators are participants who use derivatives to bet on the future direction of prices or rates of underlying assets or benchmarks. They aim to profit from price movements in the derivative markets without owning or delivering the underlying assets. For example, an investor who expects a rise in oil prices can buy call options on oil futures contracts and benefit from an increase in their value if his prediction is correct.
Arbitrageurs are participants who exploit price discrepancies or inefficiencies between different markets or instruments. They aim to earn risk-free profits by simultaneously buying and selling identical or related assets at different prices. For example, an