You are at a café, sipping your coffee, while your friend talks about the stock market. As the conversation flows, they mention the concept of equity derivatives and currency derivatives, leaving you intrigued yet slightly confused. You wonder how these financial instruments can affect the broader market and your own investments. Are they a tool for risk management or merely a gamble? You are not alone; many people feel the same way. Using a trading app can make it easier to explore these concepts and take informed steps toward investing. Understanding derivatives is crucial for anyone involved in trading or investing; this article will help you with that.
What is a Derivative?
Derivatives refer to the financial instruments that get their value from an underlying asset. This asset could be anything from stocks, bonds, commodities, currencies, or market indices. The primary objective of derivatives is to manage risk or to speculate on price movements. They can hedge against potential losses or leverage investments, amplifying both possible gains and losses.
History and Evolution of Derivatives
The concept of derivatives dates back to ancient times. Long ago, in Mesopotamian civilisation, farmers used debt waivers as a way to mitigate risk, a process resembling derivatives. Centuries later, merchants in Greece used forward contracts to manage price risks for commodities such as olive oil.
However, the derivatives market as we know it today was developed in the 19th century by establishing the Chicago Board of Trade. The board introduced standardised contracts that eventually led to the creation of the Chicago Mercantile Exchange.
The derivatives market evolved in the 20th and 21st centuries by introducing financial contracts like options and futures in stocks and interest rates. A noted event was the introducing of the Black-Scholes model in 1973, which became a fundamental tool for pricing options. Not only that, Regulatory reforms, particularly the Dodd-Frank Act of 2010, improved market transparency and stability.
Types of Market Derivatives
Derivatives in stock exchanges are of the following four types:
1. Options
Options are contracts that provide the holder with the right, but not the necessity, to either buy or sell an asset at a predetermined price (strike price) by a specific date (expiration date). The two key types of options available for trade on the derivatives app are:
- Call Options: These give the holder the right to buy the underlying asset at the strike price. Investors opt for call options when they expect the asset’s cost to increase.
- Put Options: These grant the holder the right to sell the underlying asset at the strike price. Investors purchase put options when they predict a decline in the asset’s price.
2. Futures
Futures derivatives trading are standardised contracts that mandate the buyer to purchase and the seller to deliver an asset at a predetermined price on a set future date. Unlike options, futures contracts obligate both parties to complete the transaction at expiration, regardless of the market price.
3. Forwards
Forward contracts are tailor-made agreements between two parties to acquire or redeem an asset at an agreed price on a future date. Unlike futures, forwards are not standardised and are traded over-the-counter (OTC), providing greater flexibility in their terms.
4. Swaps
Swaps are derivatives agreements where two parties set to trade cash flows or financial instruments over a defined timeframe. The most common types of swaps are:
- Interest Rate Swaps: These contracts involve swapping fixed interest payments for variable (floating) rate payments, or vice versa, to mitigate interest rate risks.
- Currency Swaps: These involve exchanging principal and interest in different currencies, helping parties manage currency fluctuations.
Derivatives: Market Participants
Market participants are individuals or entities engaging in futures and options trading, vital for market liquidity and stability. Some of the key participants in the derivatives market are:
Hedgers
Hedgers use financial instruments, mainly futures and options, to limit the risk of price movements. A farmer, for instance, may hedge by using futures contracts to lock in a stable crop price, protecting against potential price declines.
Speculators
Speculators aim to profit from fluctuations in market prices. Unlike hedgers, they accept higher risks to achieve higher returns. They employ strategies like position sizing and stop-loss orders to mitigate risks. Their trading can improve market liquidity and aid in price discovery, although it may also increase volatility. For example, day traders frequently buy and sell securities on the same day to exploit short-term price changes.
Arbitrageurs
Arbitrageurs take advantage of price differences for the same asset across different markets. They acquire the asset at a cheaper value in one market and sell it at a higher worth in another, earning a profit from the difference. This practice aids in correcting price inefficiencies and maintains prices close to their fair value.
Margin Traders
Margin trading is borrowing capital from a broker to buy securities. This enables traders to purchase more assets than they could with their own capital, effectively leveraging their investments. However, this approach can magnify both potential profits and losses. If the value of the securities falls, traders may receive a margin call instructing them to add more funds or sell some of their assets.
Derivatives: Trading Platforms
There are two types of platforms for share market derivatives. These are:
Exchange-Traded Derivatives
Exchange-traded derivatives (ETDs) are financial contracts that are standardised and traded on regulated exchanges. Their value relies on underlying assets like stocks, commodities, or indices. Common types of ETDs include futures contracts and options. These contracts have set parameters for contract size, expiration dates, and settlement processes, contributing to their high liquidity and transparency.
Over-the-counter (OTC) Derivatives
OTC derivatives refer to financial contracts that are negotiated directly between two entities without the involvement of an exchange. This direct negotiation allows for extensive customisation, allowing the contract’s terms to be tailored to the specific needs of the counterparties. Common types of OTC derivatives include forwards, exotic options, and swaps.
How Are Options Derivatives Priced?
One of the most widely used models for pricing options is the Black-Scholes Model, also known as the Black-Scholes-Merton Model.
The crucial assumptions of the Black-Scholes Model are:
- The model infers that the underlying asset prices follow a lognormal distribution, indicating they move continuously with a stable level of volatility and drift.
- It works under the hypothesis that the underlying asset does not pay dividends throughout the option’s lifespan. This simplifies calculations but can be adjusted for assets that do pay dividends.
- The model is built on the premise that markets are efficient, suggesting that price changes are random and unpredictable.
- The Black-Scholes Model assumes there are no transaction costs or taxes, making it a more theoretical rather than practical construct.
- It presumes a fixed and known risk-free interest rate, which is essential for discounting the option’s future payoffs.
- The model specifically pertains to European-style options, meaning they can only be exercised at expiration rather than at any time before.
- One of the model’s assumptions is that the underlying asset’s volatility remains constant over time, which may not reflect real market conditions.
- The model is designed for a single period until option expiration, simplifying the pricing process compared to multi-period models.
- The assumption is that options cannot be exercised early, aligning with the characteristics of European options, which can only be exercised at expiration.
- The Black-Scholes framework operates under the assumption of risk-neutral valuation, implying that investors are indifferent to risk when evaluating expected payoffs.
The Black-Scholes Formula:
The Black-Scholes formula for a European call option is given by:
C=S0N(d1)−Xe–rTN(d2)
Where:
- (C) is the call option price
- (S_0) is the current stock price
- (X) is the strike price
- (r) is the risk-free interest rate
- (T) is the time to expiration
- (N(d)) is the cumulative distribution mechanism of the standard normal distribution
- (d_1) and (d_2) are determined as follows:
D1= {ln(S0/X)+(r+σ2/2)T} σ√T
D2 = d1−σ√T
Here, (\sigma) represents the volatility of the underlying asset.
Conclusion
Derivatives play an integral role in modern financial markets. They offer tools for risk management and speculation. Whether you are a hedger looking to protect your investments or a speculator aiming for profit, understanding how derivatives work can improve your trading strategies.
If you want to trade in derivatives, opening Demat account is the first requirement. If you are unsure where to obtain this account, consider HDFC SKY, which not only facilitates a smooth account-opening process but also provides a platform where you can trade various market instruments and receive expert recommendations that can reduce your chances of incurring losses in the market.
