Derivatives

What are Derivatives in Finance?

Derivatives are instruments to manage financial risks. Since risk is an inherent part of any investment, financial
markets devised derivatives as their own version of managing financial risk. Derivatives are structured as contracts
and derive their returns from other financial instruments.

Definition of Derivatives
If the market consisted of only simple investments like stocks and bonds, managing risk would be as easy as changing
the portfolio allocation among risky stocks and risk-free bonds. However, since that is not the case, risk can be
handled in several other ways. Derivatives are one of the ways to ensure your investments against market
fluctuations. A derivative is defined as a financial instrument designed to earn a market return based on the returns
of another underlying asset. It is aptly named after its mechanism, as its payoff is derived from some other financial
instrument.

Derivatives are designed as contracts signifying an agreement between two different parties, where both are
expected to do something for each other. It could be as simple as one party paying some money to the other and in
return, receiving coverage against future financial losses. There also could be a scenario where no money payment is
involved upfront. In such cases, both the parties agree to do something for each other later. Derivative contracts also
have a limited and defined life. Every derivative commences on a certain date and expires on a later date. Generally,
the payoff from a certain derivative contract is calculated and/or is made on the termination date, although this can
differ in some cases.

As stated in the definition, the performance of a derivative is dependent on the underlying asset’s performance.
Often this underlying asset is simply called an “underlying”. This asset is traded in a market where both the buyers
and the sellers mutually decide its price, and then the seller delivers the underlying to the buyer and is paid in return.
Spot or cash price is the price of the underlying if bought immediately.

Types of Derivatives
Derivative contracts can be differentiated into several types. All the derivative contracts are created and traded in
two distinct derivatives markets and hence are categorized as following based on the markets:

Exchange-Traded Contract
Exchange-traded contracts trade on a derivatives facility that is organized and referred to as an exchange. These
contracts have standard features and terms, with no customization allowed, and are backed by a clearinghouse.

Over The Counter Contract

Over the counter (OTC) contracts are those transactions that are created by both buyers and sellers anywhere else.
Such contracts are unregulated and may carry the default risk for the contract owner.

Derivative Categories
Generally, the derivatives are classified into two broad categories:

Forward Commitments
Contingent Claims
Forward Commitments
Forward commitments are contracts in which the parties promise to execute the transaction at a specific later date at
a price agreed upon in the beginning. These contracts are further classified as follows:

Over the Counter Contracts

Over the counter contracts are of two types:

Forward
In this type of contract, one party commits to buying, and the other commits to sell an underlying asset at a certain
price on a certain future date. The underlying can either be a physical asset or a stock. The loss or gain of a particular
party is determined by the price movement of the asset. If the price increases, the buyer incurs a gain as he still gets
to buy the asset at the older and lower price. On the other hand, the seller incurs a loss in the same scenario.
Swap
A swap can be defined as a series of forward derivatives. It is essentially a contract between two parties where they
exchange a series of cash flows in the future. One party will consent to pay the floating interest rate on a principal
amount, while the other party will pay a fixed interest rate on the same amount in return. Currency and equity return
swaps are the most used swaps in the markets.

Exchange-Traded Contracts
Exchange-traded forward commitments are called futures. A future contract is another version of a forward contract,
which is exchange-traded and standardized. Unlike forward contracts, future contracts are actively traded in the
secondary market, have the backing of the clearinghouse, follow regulations, and involve a daily settlement cycle of
gains and losses.

Contingent Claims
Contingent claims are contracts in which the payoff depends on the occurrence of a certain event. Unlike forward
commitments, where the contract is bound to be settled on or before the termination date, contingent claims are
legally obliged to settle the contract only when a specific event occurs. Contingent claims are also categorized into
OTC and exchange-traded contracts, depending on the type of contract.

The contingent claims are further sub-divided into the following types of derivatives:

Options
Options are the type of contingent claims that are dependent on the price of the underlying at a future date. Unlike
the forward commitments’ derivatives, where payoffs are calculated keeping the movement of the price in mind, the
options have payoffs only if the price of the underlying crosses a certain threshold. Options are of two types: Call and
Put. A call option gives the option holder the right to buy the underlying asset at exercise or strike price. A put option
gives the option holder the right to sell the underlying asset at an exercise or strike price.

Interest Rate Options

Options where the underlying is not a physical asset or a stock, but the interest rates are interest rate options. It
includes Interest Rate Cap, floor, and collar agreements. Further forward rate agreement can also be entered upon.

Warrants
Warrants are the options that have a maturity period of more than one year and hence, are called long-dated
options. These are mostly OTC derivatives.

Convertible Bonds
Convertible bonds are the type of contingent claims that give the bondholder an option to participate in the capital
gains caused by the upward movement in the stock price of the company without any obligation to share the losses.

Callable Bonds
Callable bonds provide an option to the issuer to completely pay off the bonds before their maturity.

Asset-Backed Securities
Asset-backed securities are also a type of contingent claim as they contain an optional feature, which is the
prepayment option available to the asset owners.

Options on Futures
Options on futures are types of options that are based on futures contracts.

Exotic Options
Exotic Options are the advanced versions of the standard options, having more complex features.

In addition to the categorization of derivatives based on payoffs, they are also sub-divided based on their underlying
asset. Since a derivative will always have an underlying asset, it is common to categorize derivatives based on the
asset. Equity derivatives, weather derivatives, interest rate derivatives, commodity derivatives, exchange derivatives,
etc., are the most popular ones that derive their name from the asset they are based on. There are also credit
derivatives where the underlying is the credit risk of the investor or the government.

Derivatives take their inspiration from the history of mankind. Agreements and contracts have been used for ages to
execute commercial transactions, and so is the case with derivatives. Likewise, financial derivatives have also become
more important and complex to execute smooth financial transactions. This makes it important to understand the
basic characteristics and the type of derivatives available to the players in the financial market.

Forward Contract
Forward Contracts
A forward contract is the most elementary form of derivatives. Over here, two parties enter into an agreement either
to buy or sell something at a future date agreed today. It can be customized to cater to the need of both parties
entering the contract. The contract specifies the underlying asset’s contract size or a lot, forward interest rate,
settlement date, specified quality, and quantity, and other items to be fulfilled to satisfy the contract.

The assets often traded in forward contracts include commodities, precious metals, electricity, oil, natural gas, foreign
currencies, and financial instruments.

Pricing Assumptions for Forward Contract

The following assumptions are used to compute forward prices:
 There are no transaction costs.
 No restriction on short sales.
 There are the same tax rates on all net profits.
 Borrowing and lending at the risk-free rate
 Arbitrage opportunities are exploited as they arise.
 Closing a Position

In contrast to a futures trade, where a buyer or seller performs an opposite transaction of their original transaction
to close a position, for a forward contract to be closed or terminated before the settlement date, there are two ways
to do so. Either transfer the contract to a third party or get into a new forward contract with the opposite trade. It is
typically complicated to terminate a contract and might attract a penalty.

Settlement for Forward Contract

Forwards can be settled in either of two ways:

Cash
It requires the counterparties to exchange the cash difference in the value of their positions. The appropriate party
receives the cash difference.

Physical Delivery
It requires the counterparties to exchange the underlying asset. Herein, the actual quantity of the underlying asset,
along with other specifications as stipulated in the contract, are delivered to settle the contract.

After a settlement, there are no further obligations to either party.

Purpose
Generally, forwards are used to hedge/mitigate the price movement risk by locking the price today for the
transaction to occur at a future date.

Value
The initial value of a forward contract is zero. The forward contract can possess a non-zero value only after the
contract is entered into and the obligation to buy or sell has been made. Since the forward price is regularly
computed to prevent arbitrage, the value must be zero at the inception of the contract.

Merits of Forward Contract

A forward contract has the following merits:
 They are easy to understand.
  It is a tailor-made contract and is flexible to adjust to the needs of both parties.
 Offer a complete hedge (i.e., delta neutral hedge) and helps in mitigating the risk.
 It can be matched with the time and cash flows of exposure.
 As it is an over the counter (OTC) contract, the price of contracts is not known to others, hence providing
price protection.
 There are no immediate cash outflows before the settlement of the contract but might require an upfront
fee, i.e., margin.
 It is a tool for speculation.
 Payoffs are symmetrical, meaning thereby, there is a distinction as one party will gain while the other makes
a loss of an equivalent amount.
 There is no daily marking of market requirements as mandatory in the futures contract.

Demerits of Forward Contract

Like every other derivative, forwards also have some demerits as follows:
 As it is a private contract, there is no liquidity.
 The counterparty risk of defaulting on the contract is excessively high.
 The market for forward contracts is extremely unorganized as it is traded over the counter.
 It may be challenging to find a counterparty to enter into a contract.

Futures Contracts – Meaning, Features, Pros, Cons, and More

Futures Contracts are a legal agreement that allows buyers and sellers to buy and sell an underlying asset at some
date in the future at a specific rate. The underlying assets could be shares, bonds, metals, commodities, etc. These
are standardized contracts in terms of quality and quantity. We also call these contracts derivative because the
contract derives value from the underlying asset and its other futures contract specifications.

Moreover, these contracts represent an obligation for the buyers and sellers to buy and sell the underlying asset at
expiry. However, the buyer and seller can end the agreement any time before the expiry. So, we can say that these
contracts give the buyer the right to buy and the seller the right to sell.

A buyer will gain from the futures contract if the price of the underlying asset goes up. So, at the expiration, the
buyer will exercise the contract and buy the asset at a price lower than the spot price.

Similarly, a seller would make a profit if the price of the underlying asset drops at the time of expiry. In this case, the
seller would be able to sell the asset at a price higher than the spot price.

Key Features of Futures Contracts

Let now us discuss the key features of a futures contract:

 A future contract could be of different types of asset classes. For instance, there are futures for shares,
commodities or currencies, indices, and more.
 These are standardized contracts, both in terms of quantity and quality. For instance, a usual futures contract
for oil is for 1000 barrels. This means to trade 10,000 barrels of oil, an investor would need to buy ten
contracts.
 Investors need to deposit margin money to trade a futures contract. But, this margin money is much less
than the total value of the contract. This allows investors to participate in the futures market even with a
small sum of money.
 Apart from making profits, investors also use these contracts to hedge their risk.

Role of Clearing Houses

Clearinghouses play a crucial role in the execution of futures contracts. They facilitate payment between the buyers
and sellers and guarantee each trade. This is why they require investors to deposit small-margin money. As said
above, this margin of money is much less than the contract value.
So, this essentially means that investors use the money of their broker or clearinghouse to trade in futures. Owing to
the high level of risk, the clearing members are generally big banks and financial services firms.

The settlement of futures contracts is daily. This means your profit or loss position will also fluctuate based on the
price movement of the underlying asset. If your loss position widens, the clearinghouse or the broker may ask you to
deposit more margin money to cover the loss. This is known as Mark to Market.

However, your final profit or loss will be calculated at the expiry or when you close the trade.

Who Trades Futures Contracts?

Primarily, there are two types of investors who use futures contracts:

Hedgers
These investors do not trade futures contracts to make a profit. Hedgers primarily seek to shield themselves or their
company from the adverse price movements of the underlying commodity.

Let us take an example of a corn farmer and a corn canner to understand what a hedger is. The farmer would not
want the prices to go down, while the canner would not want the prices to rise.

Thus, to get protection against the drop in prices, the farmer will buy a futures contract to sell corn at a specific price
in the future. Similarly, the canner will buy the right to buy corn at a future date and at a specific price. Thus, since
both have bought a contract, irrespective of price movements of the commodity, they are certain of receiving or
paying the contracted sum only.

Speculators
They are the investors who do not intend on taking delivery of the underlying asset at the expiry. Instead, they aim to
profit from the price movement of the underlying asset before the expiry. We can say that speculators trade futures
contracts like how people trade shares.

For instance, if a speculator believes that the price of corn will go up, he will buy a futures contract to lock the
current price. And, if the prices go up, the speculator will make a profit by selling the futures contract, which will now
be of more value. The speculator would have to sell the contract before the expiry to avoid taking the delivery.

Usually, speculators face allegations of massive price swings in the futures market. But their biggest benefit is that
they ensure liquidity in the futures market.

Advantages and Disadvantages of Futures Contracts

Below are the advantages of futures contracts:

Usually, a futures market has more volatility than the share market. Though this means more risk, it also means more
opportunities and liquidity for investors to make big profits.
In a futures market, an investor can make big investments even with a small amount of money. This is because an
investor usually needs to deposit 10% to 15% of the value of the trade as a margin. Thus, the real return in the case
of positive trade is quite high due to lower invested capital.
The futures contracts relate to weather and commodities. Where it is difficult to have any such insider information
relating to weather etc, hence, there could be fewer possibilities of trading futures contracts based on insider
information.
In comparison to other investments, the trading charges are less in the futures market.
These contracts are good instruments for businesses to lower their risk. And, in turn, helps them to lower their input
cost.
Below are the disadvantages of futures contracts:

Because of high volatility, investors can incur huge losses in the futures market, including their margin money.
Though the margin money requirement is relatively small, it still amounts to a big sum of money owing to the
minimum contract size. This keeps away many small investors from participating in the futures market.
A futures market is comparatively harder to understand than the stock market.
Examples
The below example will help you understand futures contracts better:

Mr. X expects the oil price to rise before May. Currently, the oil contract for May is selling for $60. So, Mr. X buys one
contract (of 1,000 barrels). Now, if near the expiry, the oil price rises to $65, Mr. A will make a profit of $5,000 [($65
less $60 * 1000]. And, if the oil price drops to $55, Mr. A would incur a loss of $5,000 [($ 60 – $55) x 1000].

The above example involved a speculator. Let us consider another example, but this time of hedging.

A producer is planning to produce a million barrels of oil in six months. Or the oil would be ready for delivery in six
months. The current oil price is $50, and the producer is okay selling the oil at this price. However, the price could
change a lot in the six months.

If the producer expects the prices to rise in the future, then he would not want to lock the price. But, if he believes
the price to drop, then he would want to lock the price by using a futures contract.

Now, assume the cost of a six-month oil futures contract is $53. By entering the contract, the producer will have an
obligation to deliver one million barrels of oil at $53.

Final Word

Futures contracts are a zero-sum game. This means that if one party loses millions of dollars, the other party gains
millions of dollars. Nevertheless, such contracts give investors another investment avenue to make big profits, as well
as hedge risk. Though the market features higher volatility, it benefits investors with low trading costs, as well as the
opportunity to earn greater profits.

What are Options in Trading – Types, Pros, Cons, and More

What are Options in Trading?
The option is a type of derivative instrument that allows its holder to buy or sell an asset at a future date and at a
certain price. What makes it different from other derivative instruments is that it provides the holder with the right
to acquire or sell an underlying asset. There is no obligation for the holder to exercise this right. If the holder does
not exercise options until maturity, then it becomes worthless, and the holder’s right gets lapse.

There are two parties involved in an option transaction. One is the option holder (having the option to buy or sell).
The other one is option writer (having obligation to buy or sell the option if the holder exercises his option).

Example of Options
Imagine your favorite mango season is around the corner, and you can’t wait to eat them! However, due to the
uncertainty of rain this season, it isn’t easy to estimate the price at which mangoes will be available this season. In
case of good rainfall, they may be appropriately priced. However, a bad monsoon may jack up the prices, and you
may have to wait for a whole another year before you can get the taste of it.

You go to the market wondering what to do. One of the fruit sellers senses your dilemma and calls out to you. You
explain your worry to him regarding the monsoon and mango prices. He comes up with an innovative solution to
your situation. He offers to sell the mangoes to you (when they arrive) at a pre-fixed price of $5 per dozen. This offer
will prevail no matter what the actual prices in the markets are. You contemplate that $5 for a dozen is the fair price
of mangoes, and it is a good deal. But there lies a twist to the situation. To book the price of $5, you will have to pay
$1 upfront. This amount of $1 is called the option price.

Options Terminology Used in Trading

Now, that you have understood what options are, it is also crucial that one is aware of the common terms used in the
options market. Following are the terms that a trader needs to know before he starts trading in options:

Options Premium
The buyer of options needs to pay a certain amount to get the right to buy or sell an asset. This amount is the option
premium. The holder needs to pay the premium whether he exercises the option. In the above example, the upfront
payment of $1 to the fruit seller for buying the option to purchase mangoes is the option premium or option price.
Strike Price
It is the rate at which the holder wants to acquire or sell the asset if they exercise the option. A point to note is that
the strike price does not change. One must not confuse it with the market price, which changes regularly. In the
above situation, $5 is called the exercise price.

Contract Size
The contract size is the minimum quantity of the underlying asset that a trader can buy or sell using options. For
instance, if a contract is for 100 shares, then to buy 500 shares, the trader will need to buy five such contracts.

Expiration Date
It is the date when the option contract expires, or all the rights and obligations of the parties under that contract are
over. And effectively, the financial value of that contract becomes zero or useless. So, a trader needs to exercise the
option on or before the expiry.

Intrinsic Value
It is the value of the option contract at the time of exercising the contract. It is the difference between the strike price
and the market price of the security under the contract.

Settlement
The settlement of the options contract takes place when the buyer exercises the option. If the holder does not
exercise the option until maturity, the option will automatically expire, and there will not be any need for settlement.

The parties involved in an option contract are – the holder and the seller of the option (also known as the writer of
the option). The holder is the buyer of the option and has a right to exercise it. The writer has an obligation to buy or
sell the underlying asset if the holder exercises his right.

Types of Options
Primarily, options are of two types:

Call Option
The call option gives the holder the right to buy (not obligation) the underlying security at a specific rate in the
future. But, for the writer, it will be an obligation to sell the security if the holder exercises the call option.

For example, Mr. A buys a call option for shares of Company X at a strike price of $50 and expiry one month later.
Now, if at the expiry, the share price goes above $50, says $60, Mr. A will still be able to buy it at $50 using the call
option.

Put Option
The put option gives the holder the right to sell the underlying asset at a certain price in the future. The trader will
exercise the put option if the strike rate is higher than the market rate of the security at the expiration period.

For example, Mr. A buys a put option for Company X shares at a strike price of $50 and expiry one month later. If, at
the expiry, Company X shares drop below $50, then also Mr. A will be able to sell his shares at $50. And, if the share
price rises above $50, then Mr. A will not exercise the option but rather sell that in the open market.

Both put options and call options can be further classified as American and European Options. An American option
can be exercised on or before the expiry date while a European option can be exercised only on the date of expiry.

How do Options Work?

Continuing with the above example, consider the following situations to understand how do options work and when
does a trader exercises the option.

Out of the Money

Assume that the actual price of the mangoes is $4. Thus, the option held, in this case, is rendered worthless. (Why
would you pay $5 for mangoes currently worth $4?) However, the maximum loss is capped at $1 (option price). In
such a scenario, the option is said to be out of money.
At the Money
The actual price of mangoes is $5. In this situation, you end up in a break-even or indifferent position since the
contract price is also $5. Here, the option is at the money.

In the Money
The actual price turns out to be $8. In this situation, exercising the option makes complete sense. You would be able
to purchase the mangoes at a price point of $5 ($6 in total considering the option price) in a market where the
prevailing price is $8. Therefore, you will be in a position of obvious advantage compared to the rest of the buyers.
This situation is called in the money.

In-the-money (ITM) is when the holder will gain by exercising options. Out-of-the-money (OTM) is when the trader
will incur a loss by exercising options. And, at-the-money (ATM) is when a trader will neither make a profit nor a loss
by exercising options.

An important point to note is that the use of options depends upon in which direction a trader expects the prices of
security to move. For instance, if more traders expect the price to rise, then the option representing this would be
more expensive. There are various other factors that play a crucial role in determining option pricing.

Determinants of Option Pricing

This concept needs to be crystal clear before understanding an option pricing model is “factors determining the price
of an option”.

 Value of Underlying Asset

 Volatility
 Dividends
 Strike Price
 Time Period
 Interest Rates

Advantages of Options
The following are the advantages of the options:
 It enables traders to hedge the risk arising from the unfavorable movement in the prices.
 It allows traders to earn a profit by using certain strategies.
 Investors can get protection from adverse price movements by just paying a small premium.
 Options give a trader the flexibility to trade any price movement they want.

Disadvantages of Options
The following are the disadvantages of the options:
 Options could be tricky to comprehend for some traders. So, investors may need to pay extra money to hire
someone to trade options.
 Options are less liquid than other markets. So, it is possible that traders may not always get the trade they
want.
 If an investor does not fully understand the risks, it could result in massive losses.

Swaption – Meaning, Features, Benefits, Types and More

As the word suggests, Swaption is a combination of the words Swap and Option. It is an option to avail of a swap,
such as an interest rate swap, going ahead. Or, we can say it gives buyers’ a right but not the obligation to enter into a
swap at a specified future date. The buyer needs to pay a premium to the issuer/seller in exchange for the option.
Another name for such an option is the swap option.

Unlike futures, these tools are not standardized, instead are OTC (over-the-counter) contracts. It means that the
parties need to agree on the terms of the agreement, including price, fixed and floating rates, expiration, and the
notional amount.
Features
Following are the features of swaptions:
 They are not standardized contracts. Or, we can say that these contracts enjoy more flexibility when it comes
to deciding on the terms of the agreement.
 Usually, big financial organizations, banks, or hedge funds make use of this option.
 Big companies use it as well to manage interest rate risk.
 Since there is a need for massive resources to manage the swaptions portfolio, they are out of reach of
smaller firms. Commercial banks are the primary market players.
 Swap contracts support major world currencies, such as USD, Euro, etc.
Benefits
Following are the benefits of swaptions:

 They allow an investor to hedge options position on bonds or the interest rate risk.
 Swap options also help financial companies to alter their payoff profile.
 They also allow investors to restructure current positions.
 One may also use the swap option to alter the tenor of an underlying swap.

How does it work?

We will consider the interest rate swap to understand how the swap options work. If you have a swaption for the
interest rate, and if the interest rate rises above the agreed level before the expiration date, you remain unaffected
from the rise. On the other hand, if the rate remains the same or goes below, you won’t exercise the swap and
borrow at the current rate.

For example, Company ABC has a borrowing facility, which will expire in six months if they do not refinance it.
However, the finance manager of the company expects the interest rate to rise above the current rate. Thus, to
eliminate the risk, the manager takes a Swaption. So if the interest rate increases above the swap rate when the
refinancing is due, ABC would exercise the swap. And, if the interest rate remains below the swap rate, ABC won’t
use the option and refinance with the prevailing rate.

Types of Swaption
Based on rights and obligations, swaption can be of two types:

Payer Swaption
Under this, the buyer has the right (not obligation) to enter into a swap contract. The buyer here becomes the fixed-
rate payer and the receiver of the floating rate. For example, a company that seeks to save itself from a rise in the
interest rate may go for a payer swaption.

Receiver Swaption
It is the exact opposite of the payer swaption. Under this, the buyer has the option to seal a swap contract. The buyer
pays the floating rate and receives a fixed rate in this case. For instance, a bank with a mortgage portfolio may
purchase a receiver swaption to save itself from lower interest rates in the future.

Since Swaptions are not standardized, the buyer and seller also need to agree on the time to enter the swap option
or the execution style. The buyer and seller have three options to choose from:

Bermudan Swaption
Under Bermudan swaption, the buyer can avail of the swap option at predetermined specific dates.

European Swaption
Under this, the buyer can enter into the swap option only after the expiration date.

American Swaption
Under this, the buyer can exercise the swap option on any date between the start date and the expiration date.

The selection of the swap option based on execution-style impacts the valuation. Thus, analysts usually go for
European-style swaptions for the Black valuation model. On the other hand, analysts go for American and Bermudian
swaptions when using Black-Derman-Toy or Hull-White models. Analysts often consider American and Bermudian
swaptions as more complex than the European options.

Cost of a Swaption
The buyer of a swap option pays a premium, which is the cost of a swaption. The amount of premium depends on
the structure of the swap, especially on the difference between the swap interest rate and the current interest rate.
Moreover, the premium also depends upon the rollover frequency and how the buyer makes the premium payment,
and the time horizon of the swap.

The premium an investor pay becomes your loss if the interest rate does not go above the swap rate on the
expiration date. It means you got no benefit by paying the premium. However, you can see the premium as insurance
against any potential rise in the interest rate.

Who are Arbitrageurs?

Arbitrageurs are usually experienced investors or traders, as it is very difficult to find arbitrage opportunities so easily
and frequently. Moreover, an investor must be very quick to execute such a transaction, which is one reason why
most retail investors who use smartphones to trade are not arbitrageurs.

An arbitrager must also be very detail-oriented and must not hesitate to take a risk. Although arbitrage is considered
risk-free, it carries enormous risk because these transactions sometimes involve betting on future price movements.
In addition, the time difference can be devastating and turn a profitable opportunity into a loss-making trade.

Furthermore, arbitrageurs play a crucial role in improving capital markets. They help identify price inefficiencies and
thus make price determination more precise. If an arbitrageur finds an arbitrage opportunity, the demand for that
security in that market increases. And the usual demand-supply rules tend to increase the price of security in the
market/segment, leading to equilibrium prices in the markets.

On the other hand, the supply of security will increase in another market, which will cause the price to fall. Thus,
prices in both markets will receive the same cancellation of any arbitrage opportunity or lead to an arbitrage
equilibrium.

Are Arbitrageur Risk Averse?

In theory, arbitrage is a risk-free trade, as it involves simultaneous purchases and sales. However, these transactions
are not without risk. This is because the price difference remains for very little time, sometimes less than a second.
The price difference is for a short time because the market automatically corrects itself due to supply and demand.
So, if an investor is unable to execute the trade in a quick time, he may have to take losses.

Another risk in arbitrage is the margin or spread. Usually, the difference in the price of securities between markets is
very small, sometimes as little as a few cents. It is, therefore, possible that even after the transaction has been
carried out, a trader will suffer a net loss in a short period of time due to transaction costs.

Therefore, it is important that arbitrageurs consider transaction costs when entering an arbitrage trade. Hence, the
biggest arbitrageurs are generally institutions that invest a lot of money, trading large amounts to make big money
out of small arbitrage differences. Therefore, since the margin is in cents or pennies, so unless you invest millions,
you will not make a big profit.

Arbitrage also becomes risky at the time of the merger, which is also the time when they are super-active because
mergers usually result in a price difference in the share price. At the time of the merger, arbitrageurs buy the target
company’s shares in the hope of profiting from the difference in the trading price and the cash payment after the
merger.

However, in a merger, there is always a chance that the merger will not be completed. And in this case, the target
company’s share price may fall dramatically, leading to large losses for arbitrageurs.

Crypto Arbitrageur
Technology has made arbitration opportunities in the capital market very rare. As a result, many arbitrageurs are now
turning to the cryptocurrency market, which is a relatively new financial market. As cryptocurrencies are highly
volatile, they are attractive to arbitrageurs as they offer arbitration opportunities.

The cryptocurrency exchanges are also new and are still in the learning phase. So they offer arbitrage opportunities.
Even Bitcoin was arbitrageurs’ favorite for a long time. Several times, it has been noted that the price of Bitcoin in
South Korea was higher than on the US cryptocurrency exchanges.

Final Words
The lack of connectivity between the various financial markets is the main reason for the price difference. As
technology has emerged, the number of arbitrage opportunities has dropped dramatically, but they still exist, but not
for long. So, to capitalize on these rare opportunities, arbitrageurs deploy state-of-art technologies to quickly identify
and execute an arbitrage opportunity.

Over The Counter Market

What is Over The Counter Market?
Over the Counter market is a marketplace that allows non-standardized and unregulated trading in financial
securities between two consenting parties. Such markets do not have any norms, rules, or regulations. There is an
absence of a formal exchange or an exchange regulator who can supervise its functioning. The markets may not have
a physical location at all and may just operate online through brokers, dealers, and their networks. Virtually there are
no reporting requirements.

Since there are no disclosure and regulations, all types of securities could be traded in OTC Market. And there is
nothing like what can and what can not be traded. This freedom leads to the trading of a lot of unstructured and
non-standardized products on such markets. These instruments can be typical derivatives and structured products,
bonds, currencies, etc. Also, these types of financial markets are useful for trading in stocks that are not listed on a
regulated stock exchange.
How does Over The Counter Market Functions?
As already said, there is neither exchange nor any regulatory body that controls such markets. Hence, dealers have a
free hand in deciding what and how much they want to trade and at what price. A buyer or a seller can enter into
bilateral contracts with the dealers or any other willing participant. An investment bank may be an intermediary that
may take care of the deal. They may decide their own terms and conditions for maturity time and delivery. It is not
necessary for them to disclose the price at which the trade occurs to anyone in the market. Thus, these markets give
way to secrecy and minimum disclosures.

However, there is always an amount of uncertainty in the trades because of a lack of rules, regulations, and an
overlooking body that can take care of complaints and grievances. There is always a “counterparty risk” in such
markets. A party to the contract can deny obligation by the contract conditions at the last moment. One can default
on the payments to be made. Also, the grieving party will not have any regulatory body to approach to file a
complaint in case of such misdeeds.

What are the Advantages of Over the Counter Market?

Boon for Unlisted and Small Companies
Over the Counter markets provide an opportunity for trading in stocks of companies that do not meet the minimum
capital requirements of bigger exchanges. They provide a place for the trading of inexpensive “penny stocks” or other
unlisted stocks. Sometimes a company cannot price its stock over a certain limit on a regulated stock exchange. This
is, however, possible in an OTC market. Also, traders can trade in stocks of companies with very poor financials or
even those that are about to go bankrupt. Such trades may give avenues for high profits against high risk.

Free from Rules and Regulations

OTC markets are free from rigid rules and regulations of a formal exchange. Hence, this makes the trade very easy
between two consenting parties. They can trade any quantity of a security at any price of their choice and take
delivery as per their own terms and conditions.

There are no or very limited reporting requirements for the central agencies. Such markets allow for a quick flow of
information among the participants. Also, no exchange fee payment is required in the absence of any regulator or
exchange.
Secrecy
There is adequate secrecy in the deals as there are no disclosure requirements regarding pricing and other contract
terms. This can be advantageous to the participants as they can further trade in that security without the new buyer
knowing about the previous deal price.

Contracts Customization
OTC contracts allow for customization as per the needs and requirements of the trading parties. Quantities, pricing,
and delivery timelines- all can be tweaked as per the requirements of parties to the contract.

What are the disadvantages of Over The Counter Market?

Along with the advantages come disadvantages of such markets too.

Liquidity risk
Many times trading securities in an over-the-counter market may result in a liquidity crunch. A seller may be willing
to sell a security, but there may be an absence of suitable buyers for the same. The absence of a regulated
mechanism in such markets may further aggravate liquidity risk.

For example, during the global financial crisis of 2008, sellers could not find any buyers for the complex derivatives
and Collateralized Debt Obligations. These complex instruments were being traded in large volumes on the OTC
market. As the housing bubble burst, buyers of such products vanished from the market, resulting in a severe
liquidity crunch for the holders.

Counter Party Risk

One of the biggest disadvantages of OTC markets is the counterparty risk that parties to a contract face. As said
earlier, one party may go back on his words and refuse to honor a contract. Moreover, one of the parties may refuse
to follow the agreement or may face financial issues. This may lead that the payment may not happen as per the
agreement. Also, a party may fail or deny making a payment when due. Such instances can shake the confidence of
participants in such markets. Also, it can lead to major financial losses for a party.

The party suffering the loss will have nowhere to file a complaint, and the erring party will not be penalized.

Volatile
OTC markets can be highly volatile and unpredictable. Due to a lack of regulations, market makers can manipulate
and move the price of a security as per their wish. Effective risk management techniques become essential for the
participants to minimize the chances of a loss.

Lack of Transparency
Parties to a contract do not have to disclose the price at which the trade occurs. All the deals happen virtually on one
on one basis with the help of intermediaries. And there is nothing like a mandatory disclosure requirement with
regard to the trade taking place. This lack of transparency in such markets may lead to an adverse or difficult
situation for some of the participants. A buyer may buy a security at a much higher price than what it is actually
worth and fail to sell it later.

Proper disclosures in regulated exchanges ensure pricing and other details are transparent and such situations do not
occur. Also, the confidence and trust level of the participants in regulated markets are much higher than in OTC
markets.

Exchange-Traded Markets – All You Need to Know

Exchange-Traded Markets are the marketplaces where all the transactions pass through a central source. Or, we can
say it is the intermediary or the platform or the conduit that connects the buyer and seller. And all the market
transactions are necessarily routed through it. Though it is an intermediary or a conduit, or an exchange holds and
yields immense power and control over the trade and its constituents. It also means that the exchange takes up all
the responsibility to ensure the parties honor the contractual obligations. NYSE (New York Stock Exchange) and
NASDAQ are good examples of exchange-traded markets.
Let us understand them with the help of a simple everyday example.

Suppose Mr. A is planning to sell his car. He can either go to a car selling website, which will have its own rules and
regulations, as well as charge a fee to sell the car. Another option for Mr. A is to give an ad for selling the car and wait
for the buyers to approach themselves.

Here, the car selling website is similar to the exchange-traded markets. On the other hand, selling the car through
ads, or without any rules and regulations, is like selling through an OTC market (discussed later).

Exchange Traded Markets – More Details

The primary purpose of exchange-traded markets is to ensure fair, efficient, and orderly trading.

In an exchange-traded market, the buyers and sellers trade securities, commodities, derivatives, and more such
instruments of the listed firms. The market factors (demand and supply) decide the prices of the securities, including
shares, debentures, bonds, and more securities, that trade on such markets.

These markets feature the association of persons. Such people will get the registration with the exchange and are
member brokers. The exchange has set rules for the brokers and companies whose securities are listed for trade.

The firms that want their shares to list on these markets need to abide by the market rules and regulations. They also
need to regularly provide information to the exchange. This information includes financial reports, audited
statements, any major change in the management, any key development about the project, etc.

Initially, these exchanges had an open outcry’ system, something similar to your local vegetable market, where the
seller shouts the price. In that system, the exchange was the trading floor or the market place and the member
brokers had to be physically present to transact and trade on behalf of their clients. But now, most of the trading is
electronic and quick, which means you trade from anywhere, and thus there is no need to be physically present to
make a trade.

Amsterdam is the oldest exchange-traded market that was established in 1602. At that time, it used to trade the
shares of the United East India Company of the Netherlands.

Now, almost every nation has one or more such markets. Moreover, some markets specialize in a particular type of
security. The London Metal Exchange, for instance, specializes in metals trading, and ICE Futures Europe deals in
derivatives.

Features of Exchange Traded Markets

The features of the exchange-traded markets are as follows:
 These markets trade in an organized manner and have a centralized exchange.
 Usually, in a transaction, there are two parties. In these markets, the counter party or the second party in all
the trades is the exchange that plays the role of an intermediary.
 These markets face heavy regulations and thus, feature less counter party risk.
 Since there is less competition among the intermediaries, the transaction cost in these markets is
comparatively higher.
 Such markets are generally used by well-established firms.
 These markets work for specific hours in the day. In contrast, the OTC markets are available 24*7.
 All the contracts remain standard ones, and the transparency also is relatively higher than in any other
market.

Over-the-counter (OTC) Markets

OTC (over-the-counter) market is another type of market that exists in parallel to the Exchange-traded markets.
Unlike the Exchange-traded markets, these markets are decentralized, or there is no central force. The OTC market
features multiple intermediaries. These intermediaries compete with each other over connecting buyers and sellers.

Such competition among the intermediaries helps to ensure lower transaction costs in the OTC markets. However, a
big drawback of such markets is the lack of regulations, and that may lead to fraudulent practices by the participants.
Still, OTC markets are the most popular ones. The growth of electronic trading has pushed OTC markets ahead of the
exchange-based markets in terms of the daily trading volume.

Final Words

Exchange-Traded Markets are a very important part of every economy. They ensure liquidity in the financial markets
and serve as a source of employment for millions of people, directly and indirectly. Usually, the size of these markets
defines the financial clout that a country has.

Futures Market
What is a Futures Market?
A Futures Market is a trading place or a financial market or financial exchange where participants can trade (buy and
sell) in futures and options contracts. These contracts give rights to the engaging parties to buy or sell pre-
determined quantities of a commodity, security, or a currency at a pre-decided price and date. Futures markets
usually have set standards, rules, and regulations. The main purpose of trading in the futures market is to hedge the
risk that can arise due to the uncertainty of future prices or just for speculation purposes.

Prices of any commodity, security, or currency are uncertain in the future. A trader can enter into a futures contract,
agreeing to buy a specific quantity of a commodity at a guaranteed future price on a future date. The date is also
certain when the contract will mature. The buyer has both the options available – either take physical delivery of the
underlying commodity or security on the maturity date. Or the buyer may opt to settle the contract by receiving or
paying the difference amount. This difference amount is the difference between the purchase price and the price
that is prevailing on the date of maturity. Thus, all such trades may end up in a profit or loss for the parties to the
contract upon expiry or maturity of the contract.

How does the Futures Market Work?

People who actually are in business do most of the Futures market trading of the respective commodities. Such
trading is done through a broker. He charges a fee for his services, which is known as commission. Only a small
amount is needed while making such a trade. This is unlike stocks, where the full amount has to be paid upfront.
Usually, traders need adequate margin money in their accounts to trade which is a small percentage of the total sum.
Brokers may ask for a minimum amount of capital with traders to operate a futures account. Futures exchange may
specify the delivery location of the deliverable too. If an alternate delivery location is also mentioned, additional
delivery charges for that location can also be mentioned.

Often, traders enter into a futures contract with no intention of taking actual delivery at the time of maturity of the
contract. Day traders intend to profit from price fluctuations in a commodity after entering into the futures contract.
They use a cash settlement agreement which means the settlement is done by means of exchange of money only,
and no physical delivery of the goods or securities.

Futures Markets generally have a regulatory body that oversees their activities and functioning. Commodity Futures
Trading Commission (CFTC) in the US and the Securities and Exchange Board of India (SEBI) in India are examples of
such regulatory bodies. Such bodies are mostly governmental agencies.

Futures Options
Similar to stock options, futures options are a risk management tool for traders trading on a futures exchange.
Futures options provide the trader an option to execute the buy or sell futures contract if specific conditions are met
in the market. At the same time, the contract gives the buyer an option but does not cast any obligation on the buyer
to fulfill the contract. However, if the buyer of the option intends to trade in the underlying asset at the expiry of the
contract, the seller of the option will have to oblige and complete the contract.

Futures options are thus less risky than a futures contract. But the right to get the option does involve a cost, and the
option buyer needs to pay a premium to buy that right. Hence, such contracts become expensive sometimes.

What is the Difference between Cash Market and Futures Market?

The Cash Market and Futures Market both facilitate trading in securities, commodities, and currencies. However,
there are many differences between the two.
Purpose
A trader can buy and sell securities, etc., in a Cash market and trade in them in exchange for cash, take delivery, hold
it and then sell it.

But the main purpose of participants in a Futures market is not trading but hedging against future possible risks. Also,
traders may participate in a Futures market for speculative purposes. And to earn quick money from the price
fluctuations of the security, commodity, or stock.

Ownership of a Company
A buyer of stocks automatically becomes part-owner of the Company of which stocks are bought in a Cash market.
He will continue to have ownership rights till the time he does not sell those stocks. In many cases, stocks are
transferred even to future generations of the original holder, and they become the owners of the company.

This is not so with the buyer of a Futures contract covering a stock. The buyer only holds the futures contract, and
stocks will have to be traded at the maturity of the contract.

Margin Money and Payment

A participant in a Cash market has to complete the trade only with cash or money. Hence, he will have to keep
sufficient liquidity in his accounts to cover his traded value.

In the case of the Futures market, the participants just need to have the required margin money in their accounts to
buy the futures contract. The rest amount will be of need at the time of maturity of the contract in case delivery is
needed. In the case of a Cash settlement agreement, even the full amount will not be needed. Only the difference
amount arising out of the position at the maturity time needs to be settled.

Trading Size
A Cash market allows trade even in a single stock of a company. This is not so in the Futures market. A trader has to
buy a minimum lot of securities or a commodity as defined by the exchange.

Bonus, Dividends, and other Stock Benefits

A stock buyer enjoys various benefits that come with a stock- bonus issue of stock, dividends if declared, voting
rights, etc.

A Futures contract holder of a stock does not enjoy these benefits.

Difference in Risk
A Cash market participant deals with less risk than a Futures market participant. A trader can trade according to the
current market prices in the Cash Market. He can hold an asset and not sell it in case of a fall in the prices of the
asset. Also, he can stop buying in case of rising prices and limit his losses.

On the other hand, a Futures market participant deals with higher risk. He will have to execute the contract at the
time of maturity or settle his position by paying the difference amount in cash. Such contracts become dangerous in
times of falling prices. Because the buyer will have to buy the asset at the pre-determined price. Even if the current
market price is much lesser than the contracted one. Similarly, a seller will suffer losses in times of rising prices. He
will have to deliver at the pre-determined price when entering the contract and suffer a loss.

Stock Exchange

What is a Stock Exchange?

It is a platform where people can sell or buy different securities such as stocks, bonds, derivatives or options, futures,
etc. Moreover, the shares of the company which is to be traded in any stock exchange should be listed on that
particular exchange. So, for example, if you want to purchase shares of any company, then that company should be
listed on the stock exchange. Or else you won’t be able to make the transaction. Therefore, any company willing to
list its shares and arrange for public subscription enters the primary market through Initial Public Offering (IPO). Thru
IPO, the company invites the public to subscribe to its shares and become shareholders of the company. Stock
exchange helps to trade for securities. Further, it also helps to determine the prices of shares based on demand and
supply.

The capital market has two active divisions:

 Primary Market
 Secondary Market

The primary market involves the issue of new securities. Whereas the secondary market deals with the buying and
selling of those securities already listed and having public shareholding. The secondary market is also known loosely
as the stock market or stock exchange, where routine trading occurs.

How does a Stock Exchange Work?

In the stock exchange, all the transactions happen amongst the shareholders and not with the company directly.
Suppose a trader wants to trade in any particular stock, then he will have to buy the shares through a stock exchange
platform. So, the trader will not purchase the shares from the company directly. But he will buy from the other
shareholders who want to sell their securities floating in the market. A stock exchange provides the facility of buying
and selling any commodity, bonds, options, etc. All the transaction recording takes place digitally and therefore is a
seamless process without any obstacles.

These stock exchanges charge their fees for each trade and that is their primary source of income. Additionally, some
of the stock exchanges have their certifications and courses through which they earn income. The other source of
their income is the Membership Fee. All the trades can occur through an authorized member of that particular stock
exchange. All these members are called the Brokers. And they earn brokerage from their clients for all the trades
taking place thru them.

Steps involved in the trade of Securities

Selection of a Broker/Sub-broker
First and foremost, the trader/investor needs to select a registered broker because transactions can be done only
through a broker/sub-broker. The broker could be an individual, company, bank, or any institution registered under
that country’s securities commission or regulator to conduct the trading of securities.

Dematerialized or Demat Account

Trading in electronic form is the standard practice now. Hence, an investor/trade needs to open a D-mat account to
trade in securities which will be held in his account in electronic form. A broker can help you in opening the same
with any of the depositories.

Orders
You can place the orders online on your own, or you can instruct the broker offline about the transaction. The broker
would issue a confirmation slip once the order is executed.

Execution of the order

The broker carries out the execution of the order. He then issues a contract note within 24 hours specifying all the
details of the transaction made, including brokerage charges and money payable or receivable from the client.

Settlement of funds
The last step involves the actual transfer of securities and settlement of funds between the buyer and seller. As
agreed upon, either on-the-spot settlement is done, or forward settlement takes place on some future date through
the selected broker.

The stock exchange plays a crucial role in reducing the risks and speculations related to the securities market. Each
exchange authorities have its own set of rules and system for smooth working and timely settlement of funds. Stock
Exchange works as a clearinghouse for all transactions related to the transfer of securities and funds between the
brokers. Brokers, in turn, carry out the settlement with their clients.

Functions of Stock Exchange

Ease of Marketability
Stock exchanges have their own rules that everyone needs to follow to carry out trade in a fair manner. It ensures the
safety of the transactions, which take place a huge amount daily. Otherwise, the investors will be skeptical and won’t
feel comfortable transacting in securities on the exchange. The stock exchange regulates the flow of transactions,
thereby making the marketability of shares quite easier. One can divest and reinvest conveniently in this ongoing
market.

Improves Liquidity
The main function of any stock exchange is to provide liquidity to its traders and investors as they know that they can
convert their securities into cash anytime without any hassle. The sale of securities can be made with a single
notification. So, the liquidity is enhanced with the availability of more cash.

Valuation of Securities
Securities of different companies can be valued at current market prices. These prices and their performance can
further be tracked/compared via various indexes. Price determination and fluctuation occur in line with the demand
and supply situation of the security/stock.

Safe Environment
The legal framework ensures the safety of transactions. In the US, the Securities and Exchange Commission (SEC)
does the job of governing and regulating the stock exchanges. In India, the Securities and Exchange Board of India
(SEBI) does this job of governing and regulating.

Smooth Functioning
The virtual medium of the stock exchange improves the quality of transactions. It leads to the smooth functioning of
the securities market. Investors are encouraged to invest, considering the benefits it offers.

Raising Capital
Stock exchanges are an important means to raise initial capital through an IPO.

Work as an Intermediary
It is important to note that stock exchanges themselves don’t buy or sell securities on anyone’s behalf but only
provide a marketplace/platform to carry out trade smoothly. The exchange also has a uniform system of payment and
settlement, which makes it all the more hassle-free and reduces the risk of price movements in any share. They have
their own integrated management information system in which all the necessary information is entered related to a
particular trade. This helps the exchanges keep a record of all the transactions taking place and regulate it properly.

Platform for all

A stock exchange is a place for all kinds of participants like hedgers, investors, speculators or traders, etc. All these
participants operate as per their interests. For example, a speculator will only trade in shares to influence the price
movements in stocks, whereas an investor will invest in stocks for long-term investment. Many people make
investments in the stock market with little financial knowledge without being fully aware of the mechanism of how it
works. Stock exchange protects the investors from financial losses and ensures a fair medium of trade. They also
regularly conduct Investor Awareness and Educational Exercises.

Economic Indicator

Stock exchanges are not only the marketplace for traders to buy or sell any security but also act as the barometer of
the economy. It means that generally, the stock exchange works concerning the happenings in the economy. For
example, if a construction company has won a contract, its shares will automatically go up and thus lead to a rise in
its share price. Simultaneously if the economy is performing well, that means that more and more people will be
willing to invest in the stock market. So if a stock exchange is not performing well, it automatically means that people
are skeptical about the economy, and the economic conditions may not be good.

Drawbacks
Along with all these advantages that any investor enjoys, there are certain drawbacks that no one can escape from.
Cost Involved
There are certain costs in the process of listing any stock over the stock exchange, which may be quite high for
companies having a smaller capital base.

Legal Reforms
Apart from this, there are various types of rules and regulations that traders need to follow that sometimes it
becomes difficult or burdensome to freely carry out trade.

Final words

Stock exchanges are the most prevalent medium for day-to-day trading and making transactions in today’s world as
the inclination towards the stock market is significantly increasing. It is becoming crucial to regulate these exchanges
properly to ensure smooth and timely completion of transactions while protecting everyone’s interest. Some of the
biggest stock exchanges are the New York Stock Exchange, London Stock Exchange, Tokyo Stock Exchange, etc.