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Chapter 1 Introduction to Derivatives

Derivatives

Derivatives are contracts whose value is derived from the value of an ‘underlying’ asset. Derivative contracts are available on a wide range of ‘underlying’ assets, such as metals, energy resources, Agri-commodities, and financial assets.

Reasons to trade in derivatives market

The benefits of trading in Derivatives are:

  • Transfer risk to the person who is willing to accept it

  • Opportunity to make profits with minimal amount of risk capital

  • Lower transaction costs

  • Provision for liquidity

Participants in the derivative market

There are generally three types of participants in the derivative market:

Hedgers

Hedgers use derivatives to reduce the risk associated with the prices of underlying assets. Corporations, investing institutions and banks use derivative products to hedge or reduce their exposures to market variables, such as interest rates, share values, bond prices, currency exchange rates and commodity prices.

Speculators/Traders

Speculators try to predict the future movements in prices of underlying assets. Based on the predictive view, they take positions in derivative contracts. Derivatives are preferred over underlying assets for trading purpose, as they offer leverage, are less expensive, and are faster to execute in size, owing to their high volume market.

Arbitrageurs

Arbitrage is a deal that produces profit by exploiting the difference in price of a product in two different markets. Arbitrage originates when you purchase an asset cheaply in one location and simultaneously arrange to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, since other arbitrageurs would rush in, thus closing the price gap.

Risks Faced by Participants in Derivative market

You should understand that derivatives, being leveraged instruments, are significantly more risky than investing directly in the underlying real assets. Risks include Counter-party Risk i.e. default by counter-party; Price Risk i.e. loss on position because of price move; Legal or Regulatory Risk i.e. enforceability of contracts; and Operational Risk i.e. fraud, inadequate documentation, improper execution, etc.

It may not be an appropriate avenue for someone of limited resources, trading experience and low risk tolerance. You should carefully read the Model Risk Disclosure Document, given by the broker at the time of signing the agreement.

Key Takeaways

  • Derivatives are contracts that derive their value from underlying assets.

  • Derivatives offer a number of benefits to the participants willing to trade in the product.

  • Three main participants in the derivative market, hedgers, speculators and arbitrageurs.

  • Since derivative is a leveraged instrument it can act as a double edged sword in some cases.

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