A derivatives market has always been a daunting one! Whenever we come across this term, this whole thing just boggles our mind!! So this is a small try to help understand the core basics of derivatives market.
Firstly, what is a derivative? A derivative is nothing but a contract between two or more parties. It is a kind of financial instrument which does not have a value of its own, but which derives its value from the assets underlying in it. The value of the derivative is derived from the fluctuations in the prices of the underlying assets. The underlying asset could be shares, stocks, bonds, currencies, commodities, etc. Examples of derivatives contract are futures, forwards, options, etc. A derivative market, hence, is simply a market where exchange or trade of derivatives takes place.
Now the parties involved in derivatives are-
- Buyer of the derivative which is referred to as holding the “long position”– He owns the contract and his position becomes profitable if the value of the asset goes up.
- Seller of the derivative which is referred to as holding the “short position”– As he has already sold the contract, his position becomes profitable if the value of the underlying asset goes down.
So basically, while dealing in derivatives, the basic stress is upon transfer of ownership of asstes rather than the asset itself.
There are two types of derivatives market-
- Over the counter (OTC) Derivatives- These do not go through any exchange or intermediary, but are privately traded between two parties.
- Exchange Traded Derivatives- These are not traded privately, but are traded through specialized derivatives exchanges.
Derivates are a very important tool for risk management for both financial and non-financial institutions. These include three main role players- the Hedgers, the Arbitrageurs and the Speculators. Each assume different roles with respect to risk taking.