What are derivatives?
Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples of derivatives are Forwards, Futures, Options and Swaps.
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From a market-oriented perspective, derivatives offer the free trading of financial risks.
What is the importance of derivatives?
There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risks involved in derivative business includes:
This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or counterparty risk, it differs with different instruments.
Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying asset/instrument.
The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks
- Related to liquidity of separate products
- Related to the funding of activities of the firm including derivatives.
Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked into carefully.
What are the various types of derivatives?
Derivatives can be classified into four types:
Who are the operators in the derivatives market?
Hedgers - Operators, who want to transfer a risk component of their portfolio.
Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.