What are Derivatives in Stock Market? – Derivatives Meaning, Definition, Benefits & Risks

By Advisorymandi
23-October-2018 11:01:48 AM
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Derivatives – Meaning & Definition

A derivative is a financial contract between two parties with a value/price that is derived from an underlying asset that both parties were agreed upon. The reason its “value derived from an underlying asset” is because derivatives have no direct value – their value based on the expected future price of the underlying asset. Speaking of underlying instruments, the common underlying instruments include stocks, bonds, commodities, currencies, interest rates, and market indexes etc. These are commonly used as an instrument for hedging and speculating purposes, which allow the risks associated with the underlying asset’s price to carried out between the parties involved in the contract. The derivatives are created to mitigate a large number of risks in the value of underlying assets which changes every now or then.

For example, a value of stock fluctuates, the exchange rate of a pair of currencies change, the price of commodities may increase or decrease, and indices may fluctuate. These fluctuations may help investors make profits but these fluctuations are like a two-edged sword. One can make big profits from a change in prices and can also lose hugely because of unexpected sudden change in prices. That’s where the derivatives come in picture. It helps investors to make additional profits by accurately guessing the future price.

Some of the commonly used derivatives are Future contracts, options, swaps, forward contracts, and warrants. However, SWAPS are the complex instruments, this is why it does trade in India but it is completely Over-the-counter (OTC). The derivative market in India is slowly but gaining its significance. At least the popularity has increased manifold since the time was first introduced in India in 2000.

 

How Derivatives Work (Example):

To understand the working of derivatives in the derivative market, let’s discuss a couple of examples explaining how derivatives work.

 

How does Options Derivative work?

The option is one of the commonly used derivatives. Let’s say a Company ABC is engaged in the production business of pre-packaged foods. Company ABC is one of the largest consumers of flour and other commodities whose prices are subject to market volatility.

Now that the company is in the business of production of pre-packaged foods, to meet their objectives, they need to purchase the commodities at a reasonable price. In order to do this, the company will enter into an options contract with farmers or wheat producers to buy a fixed amount of their crop at a certain price during an agreed period of time. If the price of the wheat moves upwards above the threshold then the company can exercise the option and purchase at the strike price. However, the Company ABC pays a premium for this kind of privilege, but do receive protection in return. But, if the company chooses not to exercise, then the producer is free to sell the wheat at market value to any other buyer. Ultimately, the partnership will act as a win-win for both parties.

 

How does Futures Derivative Work?

To understand how does futures derivative work, let’s assume that a farmer enters a future contract in August 2018 with a miller to sell 10,000 bushels of wheat at Rs 5.00 per bushel in October. At expiry date in October 2017, the market price of wheat falls to Rs 4.50, but the miller has to buy at the contract price of Rs 5.00, which is much higher than the market price of Rs 4.50. So, instead of paying Rs 45,000 (4.50 x 10,000), he’ll pay Rs 50,000 (5.00 x 10,000), and the farmer will get a higher price for his corp.

With the above two examples, it is clear that the more risk you undertake the possibility of getting a reward will be more. Thus, the speculators who participate in the derivative contract work under the assumption that the future price will be different from the expected price held by the other party of the contract.

 

Benefits of Derivatives Trading

There are plenty of benefits of using derivatives and trading in the derivative market. The one we mentioned here – options and futures contracts are the most popular ones that could be employed to meet specific needs like:

 

  1. Derivative instruments can efficiently be used to take benefits of price fluctuations in the short term and conduct transactions without selling the shares which also known as physical settlement.
  2. The second benefit of using derivative instruments is to take advantage of fluctuation in prices. As you know when someone buys a stock at a low price in a market and sell in high in another market which also known as arbitrage trading can use derivative trading to take the advantages from the differences in prices in the two markets.
  3. Third benefit investor get is the security from the fluctuation in the prices. Not just the investors but the companies who come in futures contract also take get the benefit of securing the securities against the market fluctuations. One can hedge himself/herself against a fall in the price of shares that he/she possesses. Not just that it also protects you from the rise in the price of shares that you plan to buy.
  4. Best for the last – transfer of risk! By far, it is the most important benefit of using derivatives. It allows transferring risk from risk-averse to the investors who have the appetite of risk. In derivative trading, there is a wide range of products available that allow anyone to pass on the risk.

 

 Risks Associated with using Derivatives Trading

There is a reason why derivative is called one of the most complex financial instruments. It has four specific risks which are as follows:

 

  1. As you already aware that the derivatives are based on the value of one or more underlying assets. Thus, it is very difficult to find out derivative’s real value.
  2. “Leverage” is the second risk associated with the derivative It is because generally, the future traders have to put only 2 to 10 percent of the contract into their margin account to maintain that amount until the contract expires or is offset. In commodity derivatives, when there is a drop in commodities prices, covering the margin account could lead to huge losses.
  3. The third risk is the “time restriction” which could be dangerous as much as leverage risk in derivative trading.

 

Hope, this article helped you in understanding the meaning and definition of derivatives and what are the benefits and risks in using derivative. Nevertheless, if you have any query or would like to add something then doesn’t forget to mention in the comment section below. We will be happy to answer all your questions.

 

Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.  

 

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Author: Advisorymandi

AdvisoryMandi is India's most trusted Stock Market Advisory marketplace covers NSE, BSE, MCX & NCDEX. Invest with confidence and harness the power of AdvisoryMandi to make smarter investment decisions in Stocks, Indices, Commodities, Forex & IPO.

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