What are Derivatives & How are They Used?

"Derivatives are financial weapons of mass destruction." — Warren Buffet

 

Introduction

 

Derivatives are a perfect example of a double-edged sword. The term “financial weapons of mass destruction” coined by Warren Buffet for derivatives is apt. 

 

In the past, many big corporations have witnessed the wrath of derivatives to the extent that they even ceased to exist, such corporations include giant companies like Enron and Lehman brothers. As a matter of fact, derivatives were pivotal in the destruction of the World’s Financial System during the 2007-08 financial crisis. 

 

Derivatives trading is a subject almost all of the new traders are enticed by. Theoretically, derivatives are extremely potent instruments that have with them the potential to reward infinitely. 

 

But, most of the traders who trade in this segment lose 90% of their capital in the first 90 days and this is because of derivatives' innate capacity to wipe away a person’s wealth.

 

Derivatives

 

A derivative can be understood as a financial instrument whose value is derived from the value of an “underlying” asset. What this means is that there is a tool present in the financial industry which has its value dependent on the value of a different asset which is the underlying asset. 

 

Essentially, an asset is there, this asset could be a commodity like gold, silver, etc, or it can be the stock of a company, it can be a million different things as well. The need to make a separate tool which has its value derived from the value of the asset gave rise to the innovation of derivatives.

 

There has been and continues to be innovation in the financial industry which is responsible for a better financial environment that in turn facilitates transactions in a more business-friendly and economy-friendly way. 

 

According to some analysts, the size of the derivative market is 10 times the size of the world’s GDP making the derivative market humongous. Therefore, derivatives are a strong force to respect and not reckon with. 

 

(Reference: John C.Hull, Sankarshan Basu - Options, futures, and other derivatives - 2018, Pearson)

 

(Must check: What is Financial Analysis?)

 

 

Purposes of Derivatives

---

Purpose of Derivatives

---

1. Speculation purpose of Derivatives:

 

The first derivative contract was traded in 600 BCE in ancient Greece wherein a philosopher named Thales of Miletus traded on a derivative of olive oil. 

 

• He predicted a season with great harvest in the near future using his expertise in astronomy. 

• Then negotiated a contract- a derivative contract in which he gained much more than if he had just held the underlying asset- olive oil (in this case). 

• As per the contract, he could buy crude oil at a pre-negotiated price and he just had to pay some amount for the provision and benefited from the rising oil prices during that time. 

• Wherein, he got them at a way cheaper price than what they were being sold for in the market. 

 

This is one of the ways in which derivatives are used and this is the speculative purpose of derivatives.

 

Due to the high-risk associated with speculation, derivatives are often frowned upon. It should however be noted that derivatives are traded in much, much more volumes in markets all over the world than their underlying counterpart. 

 

Derivatives have much more liquidity as well. The structure of derivative contracts, no doubt make them enticing and provide a much bigger reward if correct, they pose huge amounts of risks as well due to their speculative nature. Most of the trading in derivative contracts today is done for speculative purposes.

 

(Suggested blog: Fundamentals of Technical Analysis)

 

 

2. Hedging purpose of derivatives: 

 

The development of derivatives and the inclusion of derivatives in the markets is attributed to the hedging purpose of derivatives. Just like speculation is the risk-taking purpose of derivative, hedging is the risk-adverse purpose. It serves the purpose of insurance on an investment. 

 

In each and every investment there are several risks involved which may present a loss in the future. In such scenarios, hedging provides a cushion to the investor and protects him from incurring all of the loss. 

 

It however, decreases the profitability in profitable times due to a certain amount of payment being done to buy the insurance in any case. Hedging may be done in the investment itself or a correlated asset. 

 

 

3. Arbitrage purpose of derivatives: 

 

Arbitrage is the process of getting profit from the markets by means of capitalizing on certain select opportunities provided by the markets. Consider the price of an asset more in market A than in market B. 

 

An arbitrageur can buy the asset from market B and then sell it at a higher price in market B thus gaining from the price differential. It is however a rare phenomena and is becoming even more rare with an increase in automation.

 

 

How are Derivatives Used?

 

Derivatives are traded in 2 different ways:

---

Different ways of using derivatives

---

1. Exchange-Traded

 

There are 2 major exchanges in the Indian stock market: the NSE (National Stock Exchange) and the BSE (Bombay Stock Exchange). Derivatives can be traded on exchanges wherein the exchange provides a platform for the transactions being done on the derivatives. 

 

It is similar to trading stocks in these markets. Exchange traded derivatives were first introduced in June 2000 with the introduction of index futures in the NSE.

 

Advantages of Exchange-Traded derivatives

 

• Liquidity: Derivatives that are traded in the exchanges are far more liquid than most of the other types of instruments traded all over the world. This is attributed to the structure of these instruments (standardized contracts, transparent price) which makes these instruments appealing to a lot of market participants which then enter such instruments and increase their liquidity. 

 

Liquidity is also attributed to the relative ease by which these instruments can be bought and sold. The stock exchanges and brokers all over the world keep on making it easier for participants to trade derivatives on exchanges. 

 

Today, these products can be traded in nano-seconds as well, such is the magnitude of its liquidity and with the exponential increase in the number of market participants, the liquidity of such instruments has also increased in the past few years.

 

• Risk of Default: Since there are two parties involved in any transaction, there is always a corresponding risk that one of the parties may default in case the agreement turns out to be not in their favour. 

 

Such a scenario is quite visible in Over The Counter (OTC) markets. It is however eliminated in the Exchange-Traded derivatives. Thus, exchange traded derivatives eliminate the default risk for the market participants.

 

• Regulations: There are certain regulations imposed by the SEBI (Securities and Exchange Board of India). The purpose of these regulations is to protect the small players (the retail participants) from the big players (the institutional participants- both domestic and foreign and the high networth individuals). Therefore, exchange-traded derivatives are much safer for small players than any over the counter agreements.

 

(Recommended blog: What is Fundamental Analysis?)

 

Disadvantages of Exchange-Traded derivatives:

 

• Flexibility: Since the derivative contracts traded in the exchanges are standardized and face regulations, they can not be made custom according to a participant’s particular requirement. 

 

For this purpose, Over The Counter markets exist. Usually, big participants or corporations might have some investment or business prospect which creates a need for special insurance. Here, Exchange-Traded derivatives would not help.

 

 

2. Over The Counter (OTC): 

 

Over The Counter derivatives trading is done between two separate participants through bilateral negotiations. There are a lot of such markets available all over the world and the basic principle behind such markets is that they provide customizable agreements. There is no exchange or any other intermediary involved in such agreements.

 

Advantages of Over The Counter derivatives:

 

• Customizability: Usually the agreements made in OTC markets are need-based and therefore made-to-order. This gives the buyer flexibility in choosing the terms and conditions which suit him/her the best and the seller extra premium for the service of insurance being provided. 

 

Because of the nature of OTC derivatives, they reduce the financial burden and administrative costs as well as provide alternatives to corporations which benefit from such markets. Such markets are not meant for retail traders.

 

• Entry to small or unlisted companies: A small company or companies that are not listed on the stock markets can go to the OTC markets and negotiate bilateral deals to raise capital. The premium charged here however would be more than had the company been listed.

 

• Diversification: OTC markets provide much more diversification opportunities than the exchange traded markets. Since, there are not many regulations on the OTC markets, a lot of risky ventures or small ventures which might not be approved by regulators are available here. 

 

As an example, OTC markets provide opportunities to diversify geographically (throughout the world) which is most of the time not possible in exchange-traded markets.

 

(Related blog: Elasticity of Demand and its types)

 

Disadvantages of Over The Counter derivatives:

 

• Counterparty Risk: The biggest disadvantage of the OTC markets is the counterparty risk associated with such markets. Counterparty risk is the risk associated with the possibility of one of the participants in a transaction defaulting. 

 

In an OTC market, after an agreement has been negotiated, one of the parties might not follow the terms later on when things go against them, in such a case they might default and present the other party with losses. 

 

This risk is not prevalent in exchange-traded markets which have a lot of buyers and sellers at all points of time.

 

• Liquidity: OTC markets are highly illiquid. The bid-ask spread or the difference between the bid price (or the price at which buyers are willing to buy) and the ask price (or the price at which sellers are willing to sell) at a particular point of time might be quite significant. Thus essentially adding on to the premium being paid.

 

• Transparency: Usually, there is lack of transparency evident in OTC markets. Aspects of asymmetric information and moral hazards are always there in bilateral negotiations. Due to this, OTC markets often witness manipulation of one party by another.