Whether you have heard about Derivatives in the financial market or you are new to the term, this article should serve your purpose. For understanding the Derivatives Market and many more aspects surrounding the same, let us get an overview of the contents of this article.
Hence, this article covers:
- What is the Derivatives Market?
- Working of the Derivatives Market
- What are the Derivatives in the Stock Market Used for?
- Are Derivatives Dangerous?
For learning about the Derivatives market, we must first know what the Derivatives are. A Derivative is nothing but the contract which takes its value from an asset, index or rate of interest. And, this asset or instrument is often addressed as an ‘underlying entity’. Derivatives are majorly seen coming handy for insuring in scenarios where the volatility of some stocks is more than others and also, for farmers to insure the price of their produce in future. This is why Derivatives are called the shock absorbers during the times of market ups and downs.
The term Derivatives Market implies the financial market in which people get the options of Derivatives to choose from. Coming to the size of the market, according to BIS, Notional amounts of OTC (Over-the-counter) derivatives rose to $640 trillion at end-June 2019. This is up from $544 trillion at the end-2018 and the highest level since 2014. It marks a continuation of the trend increase evident since end-2016.
Although, the gross market value (actual) of all contracts is approximately $12.7 trillion. An important point is that many analysts argue about there being a difference between notional value (face value) and market value (actual).
The gross market value of OTC derivatives, summing positive and negative values, also rose, from $9.7 trillion to $12.1 trillion, led by increases in euro interest rate derivative contracts.
Going ahead, we will discuss some common Derivatives, like Forwards, Futures, Option and Swap, which people usually invest in for insuring themselves in case of adverse price movements.
Further, we will discuss in detail all those Derivative Contracts we mentioned and also the type which is known to be the most popular. Some of the common Derivative Contracts are:
A Forwards contract is known to be a contract between two parties (individuals or entities) for buying or selling any asset (at a specific decided amount) at one specific time in the future. In the case of Forwards Derivative, there are two positions people take, one is going long and other is going short. For instance, out of the two parties, the one which decides to buy in the future undertakes a long position, whereas the one which decides to sell in the future undertakes a short position.
This implies that the party assuming a long position predicts the future prices to fall further and the one undertaking a short position assumes that the prices may rise in the future. Also, the future agreed price is called the delivery price.
In case of a Futures contract, the two parties buying and selling the specified asset of a standardized quantity and quality agree upon a price (futures price) on the same day. But, the delivery and payment both happen on the decided date in the future. As in Forwards, in futures too, out of the two parties, one which decides to buy in the future undertakes a long position, whereas the one which decides to sell in the future undertakes a short position.
In the case of Option, it is a contract which implies that the owner or the buyer possesses the right (but it is not an obligation) to buy or sell an underlying asset at a specific strike price on or even before a specific date. In this case, the strike price is the fixed price or the predetermined price. As we mentioned above, the asset, index or rate of interest that the contract derives its value from is known as an underlying asset or instrument (Commonly known as an underlying entity). For this, the buyer is bound to pay the seller a premium and there are two types of options:
- Call Option - This contract implies that the owner is entitled to buy an underlying asset or instrument at the strike price.
- Put Option - This implies that the owner has the right to sell the underlying asset or instrument, again, at the strike price.
If you would like to brush on options terminology, head on over to our blog on Basics of Options Trading for a refresher.
Swap is yet another derivative, which is a contract between the two parties, where both of them agree to exchange the cash flows from each other’s underlying assets or instruments (Contracts). The exchange happens at a specified date in the future. In this case, the type of underlying asset or instrument decides the profits for each party. For instance, in the case involving two bonds, the profits are in terms of periodic interest or coupon payments. The exchanges are known as swap’s legs. The most common types of swaps are Interest rate swaps, Commodity swaps, Currency swaps and Credit default swaps which you can read about here.
A key takeaway: Options are the most widely used Derivate. Both the Call Option and Put Option play an important role.
Proceeding ahead, we will see how the Derivatives Market works?
Okay, so as we know it works for risk management with the help of a variety of different Contracts, we will take a look at its history in brief and also other aspects of its working. Derivatives originated with farmers and traders trying to hedge their produce so as to save themselves from adverse price movements in the 12th Century in Europe.
Derivatives Market is based on the principle of transferring risk in some adverse market situation.
Here are some “key participants” in the working of Derivatives Market:
- There are two prominent market participants, ones who Hedge funds or Hedgers and second, Speculators/Traders.
Hedgers help to transfer the risk of adverse price movements in the future.
Speculators help to predict future price movements on the basis of historical data.
- The third category of market players are Arbitrageurs who look to risk-proof themselves by taking advantage of a product’s price difference in two different markets. In this case, the buyer can pick a product at a cheaper rate in one market and sell it at a higher price in another market.
Now, as we have just discussed the market players who play a key role in making sure that the derivatives are well utilised, let us further take a look at how Derivatives are traded So, there are two main ways of trading Derivatives:
- Over-the-counter (OTC)
- On an Exchange
The Derivatives, which are traded Over-the-counter are unregulated. Although unregulated, OTC is a method which is opted by various traders. There is no doubt this method carries more risk since it is not governed. However, before entering into the Derivatives Market, the trader/investor must be aware of all the associated risks so as to be able to take quick actions. Such risks can be counterparty related (since there is no legal intervention), relating to an underlying asset - like its price movement and looking into the expiry of the Derivative.
Whereas, the Derivatives on an exchange are the regulated ones and thus, carry a much lesser risk. Nevertheless, it is always advised to be careful while investing in Derivatives since they are undoubtedly common as a trading instrument but also have been surrounded by a lot of controversies. For instance, one of the factors causing the financial crisis of 2008 is said to be “too much hedging”.
The conclusion here is that once you are well-aware and sound with your knowledge about the Do’s and Don’ts, Derivatives can be really helpful. We will discuss some precautionary measures and a very commonly asked question “Are Derivatives Dangerous?” later in the article.
For now, let us go ahead and find out What are the Derivatives in the Stock Market Used for?
Derivatives, as we learnt, are used basically for risk management with regard to the investments in the stock market. The different types of Derivative Contracts work in different ways and thus, they are helpful in different kinds of situations. We already know by now that the most commonly used Derivatives are of four types, i.e, Forwards, Futures, Swap and Option. Each has its own value and depends on what kind of risk management measure you are looking for. There are some uncertainties in the market, but all thanks to the Derivatives, they can be taken care of.
In the case of Volatile Stocks, Hedging plays an important role. It is a term which simply implies keeping all your investments in different places with the help of a Derivative Contract. Hedging helps eliminate the risk associated with investing in the underlying assets or instruments. Here, a derivative contract helps by making the investor’s investments in two different stocks so as to offset potential loss that may occur from more volatile stock. Some examples of Derivative Contracts useful in Hedging are Stocks, Forwards, Swaps and Options.
Let us take an example here and assume that you, as the stock trader, feel that the price of Company X’s stocks may rise over the next month. This prediction will make you want to invest in the stocks of Company X. Simultaneously, you want to keep yourself secure from any unforeseen losses.
In this scenario, you can invest in Company Y’s stock with an equal value. Say, you opt for Futures Derivative Contract for Company Y’s stock and agree to buy it at the current price but at some specified date in future. In case the price of the stock increases on that specified date, you will gain from the contract. And, if Company X’s stock prices go down in the future, your loss will be offset by the gain from the investment in Company Y’s stocks.
Also, you can enter two different markets and, with the help of a Derivative Contract you can manage offsetting your potential losses and gains. Also, Derivatives can help you make profits in case both or all the different investments gain momentum in the markets.
Let us see some Real-World Examples when Derivative Contracts have been helpful. We will take a look at the current situations.
Real-World Examples of Derivatives being helpful in Coronavirus Outbreak (Current Situation)
In the current scenario, because of the Coronavirus outbreak, we are seeing a surge in investment in Derivatives by banks like JP Morgan and Citigroup who are known to be “feasting” on.
According to Bloomberg, “The historic panic in global stock markets has spawned a fortune for some of the world’s biggest investment banks.
JPMorgan Chase & Co. and Citigroup Inc. have added about $500 million in revenue from equity derivatives trading year-to-date compared with the same period in 2019, people familiar with the matter said. Trading surged as investors rushed to bet on stock moves and protect their holdings.”
In another news by MoneyControl, it is mentioned that “Benchmark Indian indices have been extremely weak since February, largely owing to fears of the impact of the coronavirus outbreak.
Equity derivatives turnover has increased 43 per cent so far in FY20, the report added. Overall market turnover in both cash and derivatives segments have gone up 39 per cent.
The collection of dividend distribution tax (DDT) has risen 2 per cent, owing to changes in tax structure from April 1.”
Also, In FY20, the securities transaction tax (STT) collection is up 5 per cent year-on-year (YoY) at Rs 11,247 crore as of March 15, according to a Business Standard report. The reason for the high STT collection is due to the high volume of transactions in futures and options (F&O) from between April 2019 and January 2020, the Business Standard reported.
After reading the current scenario of March 2020, it should be clear as to how and when Derivatives come into use for risk management.
Now, let us talk about the Dangers of Derivatives and find out some Dos and Don’ts.
In this section, we will discuss some risks of Derivative Contracts which are well-known and are associated with Derivatives. There are some very common “risks” which one can avoid while getting into such Contracts. Others simply depend on the accuracy of your assessment, prediction and validity of other parties involved.
There are some risks we will discuss ahead and also, what has been stated by well-known investor like Warren Buffet and former RBI Governor Raghuram Rajan about these risks and for avoiding the same.
Let us take a look at these risks as these are related to:
- Huge Amount Invested
- Illusional Safety
In case you, as a trader, use derivatives with the leverage (borrowed) money, you need to be mentally prepared about the risk of investing in the borrowed money. There are several examples of investors having earned a hefty amount out of investment but also are the instances of them losing massively. This happens because of price fluctuations of the underlying assets or instruments. As mentioned by Wikipedia, you can see some instances where entities lost huge amounts with the use of leverage in Derivative Contracts:
- American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on credit default swaps (CDSs).
- The loss of US$7.2 Billion by Société Générale in January 2008 through misuse of futures contracts.
- The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
- The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
This implies that you may be at risk for incurring losses if you have not got the validity check done of the counterparties involved in the deal. A Derivative Contract which is done privately or with the private agreement may not be as risk-free as the agreement done with a legal intervention like ‘on an exchange’. For instance, stock options with the legal intervention (on the exchange) need the party at risk to deposit some amount with the exchange so as to be sure about its capability to pay in case it incurs losses. Also, in case of the swap, the exchange does a credit check of both the parties. But, in case of private agreement, there may not be such benchmarks for doing any risk analysis.
Huge Amount Invested
Whenever there is an involvement of a huge amount of funds, there is always a danger of losing big i.e., the entire invested amount. In case you have invested a huge part of your earnings, the risk you undertake is the one which you may not be able to compensate for. As mentioned by a well-known investor, Warren Buffett in Berkshire Hathaway's 2002 annual report, Derivatives can become ‘financial weapons of mass destruction’. Hence, in case the investments in Derivative Contracts are not done wisely, they can lead to a huge problem instead of helping evade the risk. This is the main reason you require to perform an accurate analysis when it comes to investment in Derivative Contracts
This implies that the safety provided by the concept Hedging may turn around for the trader and may become just an illusional safety in case the entire market goes down in event of a huge crisis. In such a scenario, the entire market hits low and no stock remains profitable enough to cover up for the investment made.
According to Wikipedia, Raghuram Rajan, a former chief economist of the International Monetary Fund (IMF) mentioned that "It may well be that the managers of these firms [investment funds] have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlation that is zero or negative in normal times can turn overnight to one – a phenomenon they term "phase lock-in". A hedged position "can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected”.
Now, the real question is Whether Derivative Contracts are so bad that they can wreak havoc in traders’ businesses or can the circumstances be under control?
Hence, to answer this, we will take a look at the contradicting statement made by Warner Buffet later in which he mentions that Derivatives are not so bad if the traders are informed enough and take the right steps.
According to the Financial Crisis Inquiry Commission in 2011, Warren Buffet stated, “I don’t think they’re evil per se…there’s nothing wrong with having a futures contract or something of the sort.” According to the New York Times, Buffett now says the real problem with derivatives has to do with overexposure by the banks and “uninformed investors.” He believes derivatives can add value to companies, including Berkshire Hathaway, as long as leaders at those companies use restraint and hold a “limited amount.”
Perfect! This was all about Derivative Contracts in this article. Let us take a look at what we discussed.
In this article, we discussed main aspects of Derivative Contracts, their definition, size and types. Then we went on to learn about the Working of the Derivatives Market, the key participants in the same and the two platforms by which you can invest in Derivatives.
Further, we discussed the Uses of Derivative Contracts and the risks associated with them. Also, we saw some current scenarios as examples which helped us see how Derivative Contracts are used/ are helpful in the time of crisis.
Last but not the least, we saw how these risks can be avoided by making wise decisions and turn them to only benefit us.
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