Confabulating Nuts and Bolts of Financial Derivatives

By Anisha Jhawar, Institute of Law Nirma University, Ahmedabad

Exordium of derivatives: What are they?

Financial derivatives, as an instrument was introduced in the year of 2000.[1] Derivatives are financial instrument that derive their value from one or more underlying assets.[2] Stocks, Indices, commodities, currencies, exchange rates or the rate of interest, anything can qualify to be underlying assets. In simpler terms, the underlying asset is a financial instrument which influences the price of the derivatives. It is used to identify the item which grants value to the contract and supports the security that is included in the agreement. The financial instrument included is exchanged as a p0061rt of the contract as agreed upon by the parties.[3]

Why do the financial derivatives matter?

These derivatives can be used in either of the sides of equation; it can reduce the risk or can assume the risk. Since the investor seeks to gain in such volatile conditions, the financial derivatives have been generally tagged as notorious instruments. The future price of the asset is speculated by these investors and it operates on the assumption that the other party has wrong belief with regard to the future market price. Generally, public disregards the derivatives whereas, it is not inherently bad. It matters because it is necessary to provide mitigated risk and ensure profits in volatile markets, and these derivatives help to achieve the purpose.[4] The derivatives aim at facilitating the temporary hedging of fluctuating price risk. Every such contract has an expiration time ranging between three to twelve months. Therefore, these contracts are also called ‘risk managing tools’.[5]

Dais for Trading of Financial Derivatives And Types of the Derivative Contracts

The derivatives can be traded on the stock exchanges or at the Over the Counter Exchange (OTC).[6] There are four prominent types of the derivative contracts in essence are:

Futures Derivatives Contract: The futures contract is a tradable and standardised contract and is based on the size, expiration and other characteristics.[7] In simpler terms, the futures contract is the contract to sell or buy the financial instruments for future at a predetermined and agreed price. This type of derivative contract is traded on the organized exchange only which essentially implies that the futures derivative contracts are not traded on the over the counter exchange. As has been stated, the contract terms of the futures derivatives contracts are standardized and are more liquid. These require the margin payments and follows daily settlement. Reversing of the contract can be done with any member of the Exchange.[8]

Forwards Derivatives Contract: Meanwhile, the forwards contract might seem to be similar to the futures contract on the face of it. But, there are great differences between the two. Forwards contracts, unlike futures contracts are the customised contracts which take place on the specified date but the price is still agreed at the time of the making of the contract. The dais for trading the forwards derivatives contract is Over The Counter Exchange. This makes a clear implication that the contract price is generally not in the public domain and each contract is agreed at somewhat different price due to the customized nature of the contract too. There is lesser liquidity and nil marginal requirements in the forwards derivative contract. Unlike futures contract, this type of derivative contract requires settlement to be made at the end of the period and the contract can be reversed only with the same counter party with whom the contract was made.[9] The forward contract can be regarded as a bilateral contract as both the parties participate in the making of the terms and conditions of the contract.[10]

Options derivatives Contracts: The term is res ipsa loquitor as it gives an investor an option or the right to exercise the option within the specified time frame at a pre-determined price often called as the strike price. Herein, the investor is not obliged to execute the contract but is at liberty to exercise the right.[11] Broadly classified, there are two types of options- call options and put options. In case of the former, the contracts grants an option upon the investor to purchase the underlying asset at the strike price while in latter, the investor has an option to sell the underlying asset at the strike price.

Swaps derivatives Contract: Swap contracts are such derivative contracts where the parties exchange financial instruments. Mostly, the swaps involve cash flows wherein one cash flow is variable and the other is generally fixed. These are traded at Over the Counter Exchange.[12]

However, with the passage of the time, many more types of the derivatives contracts have come up to the surface; such as: credit, mortgage backed security, etc.

Participants in the Derivatives Markets

To imagine derivatives market as a pyramid, it is quite right to decipher that there are hedgers at the top, and then speculators under whom are the margin-traders and at the bottom are the arbitrageurs.[13]

Hedgers are the participants who involve themselves in the price movements and are very keen to pass on the risk, even at premeditated cost. They undertake an exact opposite trade and hedge the price of the assets in the market. This implies that they pass on the risk to those who are ready to bear it.[14]

Speculators, unlike the hedgers, seek opportunities to take on the risk. There are basically two types of Speculators, day traders and position traders. Day traders are those who trade during the day and look for the fluctuations that happen in a day whereas position traders are those who sustain for seeking profits out of fluctuation that happen over a week, month or years time.[15]

Margin Traders are the not required to pay the entire value of their position. They only require depositing a fraction of the margin. These types of participants result in very high leverage factor in trading of financial derivatives.[16]

Arbitrageurs make use of the imperfection in the market and trade in low-risk by balancing when the prices get too high or too low as compared what it should be.[17]

How to Trade in Derivatives

The trading in financial derivatives can be equated with the cash segment of stock market. What is required at the first hand is to carry out a research of the derivatives market. However, the strategy that is followed is different in case of derivatives trading. The next step is to maintain a margin amount that is required to settle the trade. This keeps you on the safer side and saves you from any minute fluctuation that might happen. Also, it is required by the investors to trade through their trading account and check whether they are permitted to trade n derivatives through their account. Next step requires selecting the trade and their contract on the basis of the amount and the price of the underlying assets. Lastly, one requires waiting for the transactions and the trade to settle.

Therefore, it has been rightly said that the derivatives can be used in either of the sides of equation; it can reduce the risk or can assume the risk.


[1] Introduction to Derivative Trading, https://www.kotaksecurities.com/ksweb/Research/Investment-Knowledge-Bank/what-is-derivative-trading (last visited November 21, 2016)

[2] Basics of derivatives, Bombay Stock Exchange, http://www.bseindia.com/markets/Derivatives/DeriReports/FAQsBasicsofDerivatives.aspx?expandable=5 (last visited November 21, 2016)

[3] Underlying Assets, Investopedia, http://www.investopedia.com/terms/u/underlying-asset.asp

[4] Derivative, Investing Answers, http://www.investinganswers.com/financial-dictionary/optionsderivatives/derivative-2202 (last visited November 23, 2016)

[5] V P Wadhwa, Derivatives, (1998) 30 CLA (Mag.) 33

[6] Derivatives, Investopedia, http://www.investopedia.com/terms/d/derivative.asp (last visited November 23, 2016)

[7] Ibid. 6

[8] Basics of derivatives, BSE India, http://www.bseindia.com/markets/Derivatives/DeriReports/FAQsBasicsofDerivatives.aspx?expandable=5 (last visited November 23, 2016)

[9] Id. 8

[10] Id. 6

[11] Option, Investing Answers, http://www.investinganswers.com/node/2049 (last visited November 23, 2016)

[12] Swap, Investopedia, http://www.investopedia.com/terms/s/swap.asp

[13] Introduction to Derivatives Trading, Kotak Securities, https://www.kotaksecurities.com/ksweb/Research/Investment-Knowledge-Bank/what-is-derivative-trading (last visited November 24, 2016)

[14] Ibid. 13

[15] Ibid. 14

[16] Ibid. 15

[17] Ibid. 16

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