Derivatives have a very wide range of application in business as well as in finance & banking. There are four main types of participants in any Derivatives Market. They are:
3. Speculators and
A point to note here is that, the same individuals and organizations may play different roles under different market circumstances. Let us take a look at each one of them in detail…
Derivative contracts are bought and sold by dealers who work for banks and other security houses. Some contracts are traded on exchanges while others are OTC Transactions.
In a large investment bank, the derivatives function is now a highly skilled affair. Marketing and sales staff speak to clients about what they want. Experts help to create solutions to those customer requirements using a combination of forwards, swaps and options. Any risk the bank assumes as a result of providing such tailor-made products is managed by the traders who run the banks derivatives books. In the meantime, risk managers keep an eye on the overall level of the risk the bank is running. Mathematicians, also known as “Quants” devise the tools required to price the new products created by the experts.
Initially large banks tended to operate solely as intermediaries in the Derivatives market, matching the buyers and the sellers. Over time, however, they have assumed more and more risk themselves.
Corporations, investors, banks and governments all use derivative products to hedge or reduce their exposure to market variables like interest rates, share prices, bond prices, currency exchange rates, commodity prices etc (We have covered almost all categories of assets over which derivatives can be placed, haven’t we??)
A simple and classic example would be a farmer who sells a futures contract to lock into a price for the crop he will deliver in a future date. The buyer might be a food processing company that wishes to fix the price for taking delivery of the crop in the future or a “Speculator”
Another typical case is that of a company due to receive a payment in a foreign currency on a future date. It enters into a forward contract to sell the foreign currency to a bank and receive a predetermined quantity of domestic currency. Or, it purchases an option which gives it the right but not the obligation to sell the foreign currency at a set rate.
Derivatives are nicely suited to speculate on the prices of commodities and other financial assets or on market variables like interest rates, market indices etc. Generally speaking, it is much less expensive to create a speculative position using derivatives than by trading the underlying commodity or asset. As a result, the potential returns are that much greater.
A classic case is the trader who believes that the increasing demand or reduced supply is likely to boost the price of oil. Since it would be too expensive to buy and store actual oil, the trader buys exchange traded futures (ETFs) contracts agreeing to take delivery of oil on a future delivery date at a fixed price. If the oil prices rise in the market, the value of the futures contract will also rise and they can be sold back into the market at a profit.
In fact, if the trader buys and then sells a futures contract before they reach the delivery date, the trader never has to take any delivery of actual oil. The profit from the whole trade is realized in cash without buying anything.
An Arbitrage is a deal that produces risk-free profits by exploiting a mispricing in the market. A simple example is when a trader can buy an asset cheaply in location and simultaneously arrange to sell it at another location for a higher price. Since such opportunities are unlikely to exist for a long time, and since arbitrageurs would rush to buy the asset in the cheap location, the price gap will close very fast.
In the derivatives business, arbitrage opportunities typically arise because a product can be assembled in different ways out of different building blocks. If it is possible to sell a product for more than it costs to buy the constituent parts, then the risk free profit can be generated. In practice, the presence of transaction costs often means that only the large market players can profit from such opportunities.
In fact, many of these so called arbitrage deals constructed in the financial markets are not entirely risk free. They are designed to exploit differences in the market prices of products which are very similar but not completely identical. For this very reason, they are also called as “Relative Value” Trades
As an ending note to this post, Derivatives are complicated financial products and are partly responsible for the global economic crisis. Of course, you can’t blame the bomb for a blast and must actually blame the person who placed it in the first place. Similarly, derivatives were used inconsiderately and carelessly and the end result is for all of us to see. So, novice and risk averse investors must stay away from derivatives. Though the prospects of profit are very high, the chances of losses are also equally high.