The derivatives market has grown in size over the past century, as the value of derivatives exposure has been dwarfed by the exposure of stocks and bonds. This subject provides students with knowledge of derivative products and markets including market structure, participants and products used to manage risk and/or trade for profit.
In this subject, students will acquire the skills to analyze, price, and trade forwards, futures, swaps, and options. The topic focuses on the main markets for these contracts including exposure to derivatives on equities, interest rates, foreign exchange and commodities.
Just like stocks, derivatives are also traded on stock exchanges.
Derivatives are kind of Money bills whose value derives from an underlying asset.
These underlying assets can be stocks, bonds, commodities or currencies.
The derivatives market refers to the financial market for financial instruments such as futures or options that are value-based assets the basic.
Derivatives market participants can be broadly categorized into the following four groups:
Hedging is when a person invests in the financial markets to reduce the risk of price volatility in the exchange markets, i.e. to eliminate the risk of price movements in the future.
derivatives They are the most popular tools in the field of hedging. This is because derivatives effectively offset risk with their respective underlying assets.
Speculation is the most common market activity in which financial market participants engage. It is a risky activity that investors engage in. It involves the purchase of any financial instrument or asset that the investor speculates will be of great value in the future. Speculation is motivated by the motive of reaping profitable profits in the future.
Arbitrage is a popular profit-making activity in the financial markets that comes into play by taking advantage of or profiting from the volatility of market prices. Arbitrators make a profit from the price difference arising from the investment of a financial instrument such as bond AndStock derivatives and so on.
In the finance industry, margin is the security deposited by an investor investing in a counterparty financial instrument to cover the credit risk associated with the investment.
Derivative contracts can be classified into the following four types:
Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) within a specified period of time. American options can be exercised at any time prior to the expiration of their option period. On the other hand, European options can only be exercised on their expiry date.
Futures contracts are standardized contracts that allow the contract holder to buy or sell the underlying asset at an agreed price on a specified date. The parties involved in the forward contract not only have the right but also the obligation to perform the contract as agreed. The contracts are standardized, meaning they are traded on the exchange market.
Forward contracts are similar to forward contracts in the sense that the holder of the contract not only has the right, but also the obligation to perform the contract as agreed. However, OTC futures contracts are over-the-counter products, which means that they are not regulated and not bound by specific trading rules and regulations.
Since such contracts are non-standard, they are traded over the counter and not on the exchange market. Since contracts are not bound by the rules and regulations of a regulatory body, they are customizable to suit the requirements of both parties involved.
Swaps are derivative contracts involving two contract holders or contract parties to exchange financial obligations. Interest rate swaps are the most common swaps entered into by investors. Swaps are not traded in the exchange market.
They are traded over the counter, due to the need for swap contracts to be customizable to suit the needs and requirements of both parties involved.
The derivatives market is often criticized and looked down upon, due to the high risks associated with trading in financial instruments.
Market sensitivity and volatility
Many investors and traders avoid the derivatives market because of its high volatility. Most financial instruments are very sensitive to small changes like change in expiry period, interest rates, etc., which makes the market very volatile in nature.
Due to the high risk nature and sensitivity of the derivatives market, it is often a very complex subject. Because derivatives trading is too complex to understand, it is often avoided by the general public, and they often use brokers and trading agents in order to invest in financial instruments.
Due to the nature of trading in the financial markets, derivatives are often criticized for being a form of legitimate gambling, as they are very similar in nature to gambling activities.
A derivative is a security with a value that is dependent on or derived from an underlying asset or group of assets – a benchmark. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates and market indices.
For example, derivative contracts are used by wheat farmers and bakers in order to hedge their risks. The farmer fears that any fall in the price will affect his income and so he enters into the contract to fix the acceptable price of a particular commodity.
On the other hand, the baker, in order to hedge his risk on the upside, enters the contract so as not to incur losses as the price rises.
The main purpose of derivatives is to reduce risk and to hedge