In recent decades, financial markets have been marked by excessive volatility. As foreign exchange rates, interest rates and commodity prices continue to experience sharp and unexpected movements, it has become increasingly important that corporations exposed to these risks be equipped to manage them effectively. Price variations make it difficult for companies to determine their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk. Risk management, the managerial process that is used to control such price volatility, has consequently risen to the top of financial agendas. It is here that derivative instruments are of highest efficiency.
The word ‘derivatives’ originated in mathematics and referred to a variable that has been derived from another variable. For example, a measure of distance in kilometers could be obtained from a measure of distance in miles by dividing by 1.61, or similarly, a measure of temperature in Celsius could be derived from a measure of temperature in Fahrenheit. In a financial sense, a derivative is a financial product which had been obtained from a market for another product.
A derivative protection is an economic agreement whose value is computed from the price of anything else, such as a stock price, a material price, an exchange rate, an interest rate, or even a list of prices.
Derivative contracts are traded both on established exchanges (like NSE, Chicago Board of Options Exchange) and Over-the-Counter market (OTC). The OTC market is usually a telephone, and a computer-linked network of dealers/brokers spread far away geographically, and orders are placed and executed electronically or over the phone.
- Hedgers (Those who desire to off-load their risk exposure in a position)
- Speculators (Those willing to absorb the risk of hedgers for a cost)
- Arbitrageurs (Those who wish to have a riskless gain in the transaction of hedgers and speculators)
A merchant is an individual or body, in commerce, who deals in monetary gear similarly stocks, bonds, commodities, and derivatives, in the quantity of representative, hedger, arbitrageur, or speculator.
Derivatives are the instruments which derive their values from the underlying assets. The underlying assets may be financial assets like individual stock, stock indices, interest rate, currencies, etc. or commodities like metals, cotton,coffee, etc.
Standard derivatives involve options, forward contracts, futures contracts, and swaps. A forward contract is a customized contract between two entities, where settlement will take place on a particular date in the future at today’s pre-agreed price.
A futures contract is an agreement between two parties to buy or sell an asset at a given time in the future at a certain price.
An option represents the right (but not the obligation) to purchase or trade a security or other asset while a given time for a particularized price (the “Strike” price).
Options are of two types—calls and puts. Swaps are individual agreements between two parties to exchange cash flows in the future, according to a prearranged formula.
In 1848, future contracts originated into existence with the establishment of Chicago Board of Trade. Options were first traded in the Chicago Board Options Market in 1977. The primary functions of derivative markets are finding of prices, risk transfer liquidity and volume trading. The significant portions providing for the growth of derivatives are priced volatility, globalization of markets, technological advances and advances in financial theories.
About the Author:
Vaishnavi Agrawal loves pursuing excellence through writing and have a passion for technology. She has successfully managed and run personal technology magazines and websites. She currently writes for intellipaat.com, a global training company that provides e-learning and professional certification training.
The courses offered by Intellipaat address the unique needs of working professionals. She is based out of Bangalore and has an experience of 5 years in the field of content writing and blogging. Her work has been published on various sites related to Big Data, Business Intelligence, Cloud Computing, IT, SAP, Project Management and more.