DERIVATIVE MARKET, ITS PARTICIPANTS AND TYPES

Q1: What is a Derivative Market? Explain its Participants and Types.                              OR   

             Write note on Derivative Market.

Ans. A)  DERIVATIVE MARKET :-

A derivative is an instrument which derives its value from an underlying asset. They have no independent value, so its value depends on the underlying asset. The underlying asset may be a commodity or a security. When a person buys derivative, he buys only a contract and not assets. If it is a commodity it is called commodity derivative, if it is a security it is called financial derivative.

According to The Security Contracts (Regulation) Act derivative is defined as follows “A derivative includes

a)    a security derived from a debt instrument, share loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security

b)    a contract which derives its value from the prices or index of prices of underlying securities”.

B.   PARTICIPANTS OF DERIVATIVE MARKET :-

The participants of Derivative Market are broadly classified into three

Groups:-

1.    Hedgers :-

They participate in derivative market to lock the prices at which they will be able to do a buy or sell transaction in future. The transaction they undergo is known as Hedging. They try to reduce or avoid price risk by dealing in derivatives.

2.    Speculators :-

Speculators are risk takers who want to take advantage of future price movement of an asset. They are ready to face what hedgers want to avoid. They use derivatives to get extra leverage.

3.    Arbitrageurs :-

They watch the spot and future markets. They are interested in taking advantage of discrepancy between the prices in two different markets Whenever they see a mismatch in prices of two markets, they enter into a buy transaction in one and a sell transaction in other market so as to enjoy profitarising out of differences in prices.

C.   TYPES OF DERIVATIVES / DERIVATIVE INSTRUMENTS :-

1.    Forwards :-

Forward contracts are private bilateral contracts to settle them at some future date. It is an over-the-counter agreement. Forward contract is a contract in which the seller agree to sell and settle the deal on a specific date in future at a predetermined price. At the time of agreement there is no exchange of assets. Physical delivery of assets takes place only on the day of final settlement.

2.    Futures :-

Future contract is a legally binding agreement. It is an agreement between two parties to exchange commodity or asset for a specific price at a certain future date. Future contracts are transferable legal agreements and their terms cannot be changed during the life of the contract. They are traded in an organised exchange. The important types of futures are stock index futures like Nifty futures, interest rate futures and currency futures.

3.    Options :-

Options are contracts between the option writers (sellers) and buyers. Options grant the buyer or the holder the right but not the obligation to* buy or sell an underlying asset at predetermined price on or before any time to the specific date.

4.    Swaps :-

Swaps are generally customised transactions. They are agreements between two parties to exchange one set of financial obligations for another as per the terms of agreement.. Some of the important types of swaps are currency swaps, interest rate swaps, bond swaps and debt equity swaps.

5.    Warrants :-

It is a contract made by issuing company giving the holder the right to purchase or subscribe to the stated number of equity shares of that company within specified period of time at a predetermined price.

6.    Credit Derivates :-

They reduce credit risk. They help the banks, finance companies and other investors to manage credit risk by insuring against adverse changes in quality of borrowers. If borrowers default, the loss can be offset by gains from credit derivatives.

D.   IMPORTANCE I BENEFITS OF DERIVATIVES

1.    Derivatives reduce risk and increases liquidity in the market for underlying assets.

2.    Derivatives help to find out the future as well as current prices of underlying instrument.    ‘

3.    Derivatives act as catalysts to the growth of stock markets. They attract young investors to securities market.

4.    Derivatives provide information about the direction in which various market indices are expected to move.

5.    Derivative trading helps to transfer the risk from risk averser to risk takers.

6.    Derivatives by increasing the volume of trading, increases savings.