What are derivatives and what are the pros and cons of trading in them?

Authored by
Team Espresso
November 10 2022
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8 min read
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In the world of finance, traders and investors have access to several financial products. While the most basic products include equity shares and bonds, there are a few other, slightly more complicated products. One of the most interesting such product segments is derivatives. In the Indian markets, the most common types of derivatives are forwards, futures, options and swaps. We will look at these in greater detail below.

What is a derivative?

A derivative is a financial instrument that derives its price and value from an underlying asset or a basket of assets. Put simply, the price of a derivative is linked to the price of another asset or a group of assets. Based on the movements in the prices of these underlying assets, the prices of the derivative instruments vary. These underlying assets could be commodities, currencies, or even other financial products such as stocks, stock indices, bonds, etc. 

For example, assume that you buy a currency derivative with the USD/INR pair as the underlying asset. Now, as the USD/INR price varies, the value of the derivative contract will also change. What makes these derivatives contracts more interesting is the fact that while the prices of the contract and the underlying asset are linked, this relationship is not linear. That is, a one percent change in the price of USD/INR might lead to a bigger or smaller percentage change in the value of the derivative contract, depending on several factors.

In India, derivatives are available to traders and investors through exchanges, as well as over-the-counter (OTC). Over-the-counter products are the ones wherein a broker acts as a middleman to the buyers and sellers, without involving a centralised exchange. 

Types of Derivatives

Forwards:

A forward contract is a tailor-made agreement between two parties. It represents an agreement to buy or sell an underlying asset on a particular date in the future at a price determined today. A forward is a derivative because its price is dependent on another asset. Since these contracts are tailor-made, their terms and conditions can be customized depending on the preferences of the parties involved. While this adds to the flexibility of a forward, it also makes the market for these contracts less liquid because there is a lack of standardisation. Forward contracts are traded over the counter (OTC), i.e. not through any centralised exchange such as NSE or BSE. A forward contract is settled on the date of maturity.

For example, say Farmer A grows wheat which is currently trading at Rs 110 per kg in the market. Assume that Manufacturer B uses this wheat to produce biscuits. As the harvest season is two months away, Farmer A is afraid the price of wheat might decline to Rs 95 per kg by the time the crop is ready for sale in the market. This might result in lower rewards for the efforts of producing it. On the other hand, Manufacturer B believes lower rainfall can reduce the wheat supply in the coming months. This might increase input costs, and wheat procurement costs might jump to Rs 120 per kg. To offset their risks, Farmer A and Manufacturer B can enter into a forward contract wherein they agree to trade wheat at Rs 110 per kg after 2 months, irrespective of the market price prevailing at the time of settlement.

Two months later, on the settlement date, if the market price of wheat is Rs 115 per kg, it would prove to be a loss for Farmer A. However, if the market price is Rs 95 per kg, it would be negative for Manufacturer B. In either of the above scenarios, while there will be a winner and a loser, both parties can remove the risk associated with their business. 

Futures: 

A future contract is one of the most important forms of derivatives in the global financial markets. Each futures contract represents an obligation to buy or sell the underlying asset at a specific time and price. Futures contracts are similar to forward contracts, but the key difference is that futures contracts are traded on exchanges and are largely standardised. This means that the terms and conditions of each futures contract are very similar, and as a result, the market for these contracts is highly liquid. The profits and losses of these contracts are settled daily on a mark-to-market basis. This means that each trader's profit or loss is calculated at the end of each day. The traders who have incurred losses during the day are then required to pay that amount to the exchange, which is then sent to the traders who have made profits. The amounts are credited or debited on a (T + 1) basis.

Another important distinction between futures and forwards is regarding the settlement process. While forward contracts can be settled through physical settlement, that is, Farmer A physically delivering wheat to Manufacturer B, futures contracts are finally settled on a cash basis only. This means for future contracts, the final settlement process is similar to the daily settlement process.

Swaps:

A swap is one of the newer types of derivative contracts which allows two parties to exchange the cash flows from different financial instruments. Swaps, like forwards, are traded over-the-counter (OTC) and not through any centralised exchange. Because of this OTC trading system, swaps are not easily accessible by retail investors and are more popularly used by institutional investors. The most common forms of swaps are interest rate, currency and credit default swaps. 

For example, assume that Company A is based in India and needs $1 million for its operations in the USA at a fixed interest rate. Similarly, assume that Company B is an American company that needs Rs 7.5 crore to procure machinery in its Indian factory at a variable interest rate. Instead of Company A looking for debt in the USA and Company B looking for debt in India, the two can enter into a swap contract. Under this contract, Company A can raise Rs 7.5 crores of debt in India at an interest rate of repo rate plus 2 percent per annum and Company B can raise $1 million of debt in the USA at an interest rate of 4.5 percent per annum. On the date of entering the contract, Company A can transfer Rs 7.5 crore to Company B, and Company B can transfer $1 million to Company A. Further, the agreement can be such that on the date of settlement, the companies must exchange their interest payments every quarter with each other. Finally, the companies may also agree to exchange the principal amounts at the end of the agreement. 

Benefits of trading in derivatives

Hedging

One of the most important uses of derivatives is that they are used for hedging, that is to reduce the risk from another investment or position. For example, a company that has to make payments in USD after 3 months can hedge itself against exchange rate fluctuations by purchasing USD/INR futures contracts today.

Arbitrage opportunities

Using derivatives, some traders are able to generate small profits with extremely low risks by exploiting market inefficiencies.  

Leverage

Derivatives like futures contracts are leveraged financial instruments. This means that in order to take a position worth Rs 1,00,000 in the futures segment, a trading member need not have the entire sum ready in their account. This is because they just need to put the initial margin and ensure that they have enough funds (greater than or equal to the maintenance margin) throughout the life cycle of the futures contract. This is usually just 25-30% of the overall value of the contract. Thus, just with Rs 30,000, a trader can hold positions of Rs 1,00,000 and stand a chance to make higher returns.

Disadvantages of derivatives

High risk

Derivatives are relatively more volatile than other asset classes such as equities and bonds. Further, taking certain positions in derivatives such as options can expose traders to theoretically unlimited losses. This might cause financial adversities for traders.

Speculative

Derivatives are highly risky products and are often traded with the sole motive of making speculative gains. A movement against the direction in which a trader has placed a bet can wipe out a large portion of their portfolio. Because these assets are volatile by nature, such movements are not unlikely and hence, speculation is likely to lead to huge losses. 

Conclusion 

Derivatives are financial instruments that derive their value from another asset, known as the underlying. The underlying can be a stock, bond, index or even interest rates. Derivatives are of many types, including forwards, futures and swaps. These products are mostly used for hedging, seeking arbitrage opportunities and taking advantage of the leverage. The high risks involved and the speculative nature of these instruments are the biggest disadvantages of derivatives.

FAQ

Q. What are forward contracts?

Forward contracts are agreements to buy or sell an underlying asset at a particular date in the future and at a price determined today.

Q. What are futures contracts?

Futures contracts are obligations to buy or sell the underlying asset at a specific time and price. These contracts are similar to forward contracts but tend to be more standardised and can be traded on an exchange.

Q. What are swaps?

A swap is a derivative contract that allows two parties to exchange cash flows from different financial instruments.

Q. What is the strike price?

The strike price is the predetermined price at which the two parties agree to buy or sell the underlying asset on the expiry date.

Q. What is the expiry date?

The expiry date is the date on which the derivative contract is finally settled by the two parties.

 




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