You must have heard of futures and options! A common sight in movies is a bunch of stock traders on the trading floor, making long and short calls. Perhaps the most exciting and dynamic financial security available today is a derivative.
So, what is a derivative? The most common definition of a derivative reads approximately as follows: A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
This is a simple and efficient definition. However, it also has certain drawbacks. For example, it can also describe mutual funds and exchange-traded funds, which would never be viewed as derivatives even though they derive their values from the values of the underlying securities they hold. The difference is that derivatives transform the performance of the underlying asset whereas, mutual funds and ETFs simply pass on the returns of their underlying securities.
You may be wondering, why use derivatives at all? Why can’t I just buy the stock? There are a couple of compelling reasons to use derivatives. Derivatives can be used to create strategies that cannot be implemented with the underlying alone. For example, derivatives make it easier to go short, thereby benefiting from a decline in the value of the underlying. Besides, derivatives, in and of themselves, are characterized by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount of their capital relative to the value of the underlying. As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative.
Derivatives generally trade at lower transaction costs than comparable spot market transactions, are often more liquid than their underlying, and offer a simple, effective, and low-cost way to transfer risk. For example, a shareholder of a company can reduce or even eliminate the market exposure by trading a derivative on the equity. Holders of fixed-income securities can use derivatives to reduce or eliminate interest rate risk, allowing them to focus on the credit risk. Alternatively, holders of fixed-income securities can reduce or eliminate credit risk, focusing more on interest rate risk. Derivatives permit such adjustments easily and quickly.
On following the equity markets, you may notice the two most common derivative instruments that exist – futures and options.
Formally, a futures contract is defined as a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
An option is a contingent claim and can be easily defined as follows: An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time before the expiration date.
The right to buy is one type of option, referred to as a call or call option, whereas the right to sell is another type of option, referred to as a put or put option.
Buying an option requires you to pay a premium. This is because an option gives you the right but not an obligation to buy/sell a particular security. In a futures contract, an individual is legally obliged to complete the transaction, and therefore, there is no premium attached to it.
It is interesting to note that India is the largest derivatives market in the world. As of January 2020, India’s National Stock Exchange has surpassed America’s CME Group Inc. to become the world’s largest derivatives bourse by volume. Mumbai-based NSE traded the most contracts in the world in 2019, the exchange said in a statement, citing data from the Futures Industry Association. Volume on the Indian exchange grew 58% to about 6 billion derivative contracts in 2019, surpassing CME’s 4.83 billion, according to FIA’s website.
Derivatives are a wonderful tool that is used widely to take advantage of market volatility. It also enables high–volume trading with low capital requirements. However, derivatives are primarily speculative instruments and the tremendous rise in their traded volumes in India represents increasing market speculation. One must carefully monitor derivative data to ensure that investors do not get caught in market turmoil caused due to highly speculative transactions.
References
Volume 6, CFA Program Curriculum, CFA Institute
https://www.nseindia.com/nse-is-now-worlds-largest-derivatives-exchange#:~:text=India% 20Now%20Has%20World's%20Largest%20Derivatives%20Exchange%20by%20Volume&text =Volume%20on%20the%20Indian%20exchange,billion%2C%20according%20to%20FIA's%20 website.