Derivatives

                                         Derivatives

Derivative is a product whose value is derived from the price of some other asset commonly known as underlying. It includes wide range of underlying assets. These include: 

1. Metals such as Gold, Silver, Aluminium, Lead, Zinc etc.

2. Energy resources such as Oil (crude oil), Coal, Electricity etc

3. Financial assets such as Shares, Bonds and Foreign exchange.

Derivatives market helps in improving price discovery. It helps in transfer of various risks from those who are exposed to risk but have low risk taking capacity. For example: Investors don't want to take the risk but traders are willing to take risk.

In Indian stock market there are two types of markets: 

1. Cash Market

2. Derivative Market

Derivatives are typically used for three purposes:

a) Hedging

b) Speculation

c) Arbitrage

A) Hedging

When an investor has an open position in the underlying, he can use derivative market to protect the position from the risks of future price movements. Without selling the assets from the portfolio investor can sell it in derivative market.

B) Speculation

A speculative trade in a derivative is not supported by an underlying position in cash, but simply implements a view on the future prices of the underlying, at a lower cost. Alternatively, he can take a long position in that stock through futures market as well. In derivatives, market you got a high amount of leverage this sometimes make derivative market risky. If the market had moved against his prediction, he would have incurred huge losses compared to the spot market.

C) Arbitrage

If the price of the underlying is Rs 100 and the futures prices is Rs 110, anyone can buy in the cash market and sell in the futures market and make the costless profit of Rs 10. This is called arbitrage. Arbitrageurs are specialist traders who evaluate whether the Rs 10 difference in price is higher than the cost of borrowing. Other highly traded derivatives in global markets are for currencies, interest rates and commodities.