Financial derivatives are contracts whose value is derived from the underlying asset.

Hedgers
and speculators widely use these contracts to take advantage of market volatility. The buyer
of the contract agrees to buy the asset at a specific price on a specific date. Similarly, the
seller also enters into one such contract. The different types of derivatives include futures and
options, forwards and swaps. This article covers in detail what financial derivatives are, how
it works, types and the different players in the derivatives market.
What are Financial Derivatives?
Derivatives are financial contracts. The value of financial derivatives is dependent on the
underlying asset. The assets can be stocks, bonds, commodities, currencies, etc. The value of
the underlying asset changes with the market movements. The key motives of a derivative
contract are to speculate on the underlying asset prices in the future and to guard against the
price volatility of an underlying asset or commodity.
To better understand a financial derivative, let us take an example of Company ABC. You are
certain that the share prices of Company ABC are likely to go up. You can buy a derivative
contract by placing an accurate bet to leverage the price movement. Furthermore, derivative
contracts can also act as a cushion for your investment to limit losses.
Taking another example, derivative contracts are used to fix the price of a commodity to
minimise losses. For instance, dealing in the commodities market doesn’t necessarily involve
the physical delivery of the commodity. To elaborate, a futures contract for onions doesn’t
involve buying and selling onions. The value of the contract is derived from the cost of
buying and selling onions.
Therefore, derivatives aim to create a balanced exchange rate for assets. Hence, they are
popular options to hedge against price volatility.
How Does a Derivative Market Work?
Trading in the derivatives markets is more or less the same as dealing in the cash segment of
the stock market. You will require a trading account to deal in derivatives.
Trading in the derivatives market is through Exchanges and Over the Counter (OTC).
 Exchange-Traded Derivatives: Contracts that take place through a broker are
exchange-traded derivatives. Futures and options are exchange-traded derivative
contracts. When you purchase a stock option, you will be purchasing the option
instead of the security.
 Over the Counter Derivatives: Contracts that take place directly between two parties
are over the counter derivative contracts. Forwards and swaps are over the counter
contracts. As a result, these contracts are customised to suit the requirements of both
parties to the contract.
Furthermore, financial derivative contracts are not risk-free. They come with an inherent risk
of market volatility. Therefore, it is risky to trade in the derivatives market without proper
hedging mechanisms.
Who are the Participants in a Derivative Market?
Derivatives trading requires a good understanding of the stock market. Knowledge and time
to track the stock market movements are primal for participating in the derivatives market.
Therefore, derivatives are not everyone’s ball game.
Following are the participants in the derivatives market:
 Hedgers: The main focus for hedgers is protection. Often known as risk-averse
traders. Hedgers like to protect themselves from possible price fluctuations in the
future. Hedgers are active in the commodities market where the price fluctuations are
 rapid. Futures and options trading can offer them the much-needed price stability in
such instances.
 Speculators: Speculators are risk-takers who wish to earn good profits. They
constantly monitor the markets, the news, and any other information that could affect
their trading. As a result, speculators place an educated wager on the underlying
asset’s price. In simple terms, speculators seek to purchase an asset at a lower price in
the short term while betting on bigger returns in the long run.
 Arbitrageurs: Arbitrageurs take advantage of the price difference of the same asset
across different exchanges. Arbitrageurs buy securities at a low cost in one market
and sell them at a higher price in a different market.
 Margin Traders: Brokers in the derivatives market require a deposit/ margin amount
from investors. Margin amount is a minimum amount that investors have to deposit
with the broker to trade in the derivatives market. As a result, the trader can maintain
a sizable outstanding position.
Types of Financial Derivatives
The most popular types of Financial Derivatives are:
Futures
Futures are a type of derivatives contract where the buyer and seller enter into an agreement
to fix the quantity and price of the asset. The agreement has the quantity, price and date of the
transaction mentioned. Upon entering into the contract, the buyer and seller are obligated to
fulfil their duty regardless of the asset’s current market price. Futures contracts are popular
for hedging risk and speculation. However, the main purpose is to fix the price of the asset
against volatility.
With a futures contract, you can take advantage of the margins. A margin requirement is a
minimum amount that you must deposit in order to trade futures on an exchange. The higher
the leverage, the lower is the margin.
For example, if a commodity’s exchange margin is set at 5%, the leverage is 20 times. This
indicates a deposit value of INR 5; you can trade for INR 100. The trader must repay the
entire amount when the contract expires. As a result, higher leverage indicates high risk.
Options
Options also derive their value from the underlying asset. The option holder is not obligated
to buy or sell the asset on expiry. Following are the two types of options:
 Call Option: The buyer of a call option has the right, but not the obligation, to
purchase the asset at the stated price on the specified date. For example, if you buy a
call option on Company ABC to buy 100 shares at INR 200 on a certain date. The
share price of Company ABC has plummeted to INR 150 on the expiration date.
As a result, you are unwilling to execute the contract since it is a loss proposition. You have
the option not to purchase the stock. You will just lose the premium paid to enter the contract
in such a case. As a result, instead of losing INR 5,000, you will just lose the premium you
paid.
 Put Option: A put option holder has the right but not the obligation to sell the
underlying asset at a specific price on a specific date. Suppose you acquire a put
option on a Company ABC to sell 100 shares at INR 200 on a certain date, for
example. The share price of Company ABC has increased to INR 250 on the
expiration date, and you are unwilling to execute the contract since you would lose
money. You have the option of not selling the stock and saving INR 5,000.
Forwards
Forward contracts are similar to futures contracts. The contract holder is under the obligation
to fulfil the contract. However, these contracts are not standardized and do not trade on the
exchange. Forward contracts are over the counter contracts. As a result, these are customized
contracts to suit the requirements of the buyers and sellers (parties to the contract).
Swaps
Swaps are derivative contracts that help two parties to exchange their financial obligations.
Corporates use swap contracts to minimize and hedge their uncertainty risk of certain
projects. There are four types of swaps. Namely, interest rate swaps, currency swaps,
commodity swaps and credit default swaps.
The most popular type of swap is a credit default swap. A credit default swap provides
insurance from a debt default. The buyer of the swap gives the seller the premium payments.
In case of a default, the seller will pay the buyer the face value of the asset. At the same time,
the seller will get possession of the asset.
Why Do Investors Choose Financial Derivatives?
Following are the key reasons why investors choose financial derivatives:
 To address market volatility: Financial assets are highly volatile. The price
fluctuations can often lead to heavy losses. You can leverage the financial derivatives
to minimise your losses. Suitable derivatives contracts can help shield you from price
falls as well as price rise, as the case may be.
 Arbitrage opportunities: Derivative contracts have good arbitrage opportunities.
Arbitrage involves buying an asset at a low price in one market and selling it at a high
price in another market. The difference between the prices is the profit that you will
make.
 Access to different assets and markets: Derivatives can help businesses gain access
to assets or markets that might otherwise be unavailable. For example, interest rate
swaps allow a corporation to get a better interest rate than it could get from direct
borrowing.
Advantages and Disadvantages of Financial Derivatives
Advantages
 Lock in Prices: With derivatives, investors can lock in the prices of the assets. If they
expect the asset prices to go down in the future, through derivative contracts, they can
lock in the present prices.
 Hedging: Derivatives are popular for hedging. Individuals can enter into a derivative
contract where asset value moves in the opposite direction to the asset value they
already own.
 Leverage: Derivatives are leveraged products. Investors can get access to higher
capital through leverage, i.e., they can get access to more money than actual cash in
hand.
Disadvantages
 High Risk: Derivatives are high-risk investment options. Their high volatility may
lead to huge losses.
 Leverage: Leverage can work as an advantage as well as a disadvantage. If the asset
prices move in the opposite direction than your anticipation, the losses can be huge.
 Counter-Party Risk: Some derivative contracts are over-the-counter contracts. For
such contracts, the counterparty default risk is high.
 Parameter Forward contract Future contract
Contract type Tailor made contract Standardized contract
Organized stock
Traded on Over the counter
exchange
Settlement happens On the maturity date Daily
Risk High Low
The size of the contract is fixed No. It depends on the contract terms Yes
Based on the terms of the private
The maturity date is Predetermined
contract
Zero requirements for initial
Yes No
margin
The expiry date of the contract Depends on the contract Standardized
Liquidity Low High

Basis for
Forward Contract Futures Contract
Comparison
Forward Contract is an agreement A contract in which the parties agree to
between parties to buy and sell the exchange the asset for cash at a fixed
Meaning
underlying asset at a specified date price and at a future specified date, is
and agreed rate in future. known as future contract.
What is it? It is a tailor made contract. It is a standardized contract.
Over the counter, i.e. there is no
Traded on Organized stock exchange.
secondary market.
Settlement On maturity date. On a daily basis.
Risk High Low
As they are private agreement, the
Default chances of default are relatively No such probability.
high.
Size of contract Depends on the contract terms. Fixed
Collateral Not required Initial margin required.
Maturity As per the terms of contract. Predetermined date
Regulation Self regulated By stock exchange
Liquidity Low High