In this post, we will discussed here Derivatives Contracts Meaning, Types, Importance of Derivatives Contracts, Problems.
Derivatives Contracts Meaning
The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be financial securities, securities indexes, reference rates, interest rates and some combination of them. Today, around the world, derivative contracts are traded on electricity, weather, temperature and even volatility. Common instruments of derivatives are futures, options, forward and swaps.
According to the Securities Contract Regulation Act, (1956) the term “derivative” includes:
(i) 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;
(ii) A contract which derives its value from the prices, or index of prices, of underlying securities.
Derivatives are used for a variety of purposes. They can be used to reduce risk by allowing the investor to hedge an investment or can be used as for speculation in stock market or can be used as a sort of insurance policy against adverse market movements.
For example, if a firm need petroleum on a regular basis, then they can guard against rise in the price of oil by purchasing call option. If market price of oil is low then call option is not exercised but if the market prices of oil increases then call option can be exercised to buy oil at below market price.
Types of Derivatives Contracts (Components or Instruments)
Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps. Over the past couple of decades several exotic contracts have also emerged but these are largely the variants of these basic contracts. Let us briefly define some of the contracts:
1. Forward Contracts:
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price.
Other contract details like expiration date, price and quantity are negotiated bilaterally by the parties to the contract. On the expiration date, the contract has to be settled by delivery of the asset. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are as given below:
1. They are bilateral contracts and hence exposed to counter-party risk.
2. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
3. The contract price is generally not available in public domain.
4. On the expiration date, the contract has to be settled by delivery of the asset.
5. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.
2. Future Contract:
A futures contract is simply a legal agreement between two parties to buy or sell an asset at a certain time in the future at a predetermined price.
There are two parties to every futures contract – the seller of the contract, who agrees to deliver the asset at the specified time in the future, and the buyer of the contract, who agrees to pay a fixed price and took delivery of the asset.
Futures contract are mainly used for hedging but change in prices of the underlying asset of the future contract provide gains to one party at the expense of the other.
The futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:
- Quantity of the underlying
- Quality of the underlying
- The date and the month of delivery
- The units of price quotation and minimum price change
- Location of settlement
Features of Future Contracts:
1. Future contracts are standardised where conditions relating to date, quantity and delivery are fixed. It cannot be negotiated between buyer and seller.
2. Future contracts are regulated by SEBI.
3. Prices of various future contracts are available in stock exchanges.
4. Future contracts are more liquid because participants involved in future contracts are more.
5. Counter party risk in case of future contracts are less.
6. Initial margin is required in case of future contract.
7. Futures contracts are traded in stock exchange and it is transferable.
8. In futures the balance is settled everyday (also called mark to market settlement).
3. Option Contracts:
Option is basically an instrument that is traded at the derivative segment in stock market. Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract. While buying an option a contract the buyer has the right to exercise the option within the stipulated time period but he or she is not bound to exercise that option. On the other hand if the buyer is willing to exercise the option the seller is bound to honor that contract. In option trading the price that is agreed up on for trading is called the strike price and the date on which the option contract is going to expire is called the expiration time or expiry. There can be different underlying assets for which options are traded including stocks, index, commodity, derivative instrument like the future contract and so on.
A Swap is an agreement between two parties to exchange one set of cash flows for another which is calculated according to a predefined formula. A swap is nothing but a barter or exchange but it plays a very important role in international finance.
Usually, when the swap contract is formed at least one of these series of cash flows is determined by a random or uncertain value like interest rate or equity price etc. Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges.
Importance of Derivatives Contracts
In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.
1. Discovery of prices: Prices in an organized derivatives market reflect the perception of market participants about the future price of the underlying asset. The prices of derivatives converge with the prices of the underlying asset at the expiry of the derivative contracts. Thus derivatives help in discovery of future as well as current prices.
2. Transfer of risk: The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
3. Growth of Capital market: Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses’ higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
4. Risk management at low cost: A wise use of derivatives can provide a new mechanism to manage or reduce various financial risks at low transaction cost.
5. Organised derivative market: Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.
6. Huge profits: Financial derivatives can be used to speculate and make huge profits by assuming certain risks probably with suitable degree.
7. Creates entrepreneurship: An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
8. Assets management: A financial derivative plays an important role in asset management due to their low transaction costs as compared to the spot market instruments.
In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
Problems with Derivatives Contracts:
1. Possibility of Huge Losses: The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset’s price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.
2. Counterparty Risk: This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.
3. Posing high risk to small and inexperienced investors: Since the Derivative markets give an opportunity for an individual to earn huge profits; it’s often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them.
4. Lack of proper education on derivative contracts: Derivatives contracts are still new in Indian stock market because maximum investors do not what actually derivatives are? They mainly trade on tips given by brokers and sub-brokers. Lack of proper knowledge of derivative contracts hinders the growth of derivative markets in India.