Participants in Derivative Market
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:
Derivatives contracts are of three types – future, options and forward contract. Future and options contract are traded on stock exchanges while forward contracts are OTC transactions. All the Derivative contracts are bought and sold by dealers who work for banks and other security houses. A dealer mainly acts as a middleman between the buyers and sellers of derivatives contracts. Derivatives function is now a highly skilled affair and requires expert knowledge because the risk involved in derivatives are very high. Dealers and their supportive staff must have adequate knowledge of stock market and also registered in stock exchanges. Dealers of derivatives contracts normally have a team of Experts who helps their clients in taking trading decisions in derivatives contract.
Hedgers in stock market are those who use derivatives products to hedge or reduce their exposure to market variables like interest rates, share prices, bond prices, currency exchange rates, commodity prices etc.A hedger can be Corporations, investors, banks, governments, institutional investors and also individual investors who can use derivative products to hedge or reduce their risk involved in their investments. 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.
Speculators are persons who buys or sale securities and derivatives contracts with a view to make profits by taking the advantage of fluctuations in prices in stock market. Speculators are short term investors and they take their decision on technical basis and by observing the prices of financial instruments in current market situations. Speculators can also be called gamblers. Derivatives instruments are nicely suited for speculators because speculators can make huge profits at minimum investments in derivatives a contract which is not possible by directly investing in underlying commodity or asset. Potential returns in derivative contracts are that much greater as compared to direct investments in underlying commodity or asset.
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 taking the advantages of difference in prices of financial instruments in two different markets. A simple example is when a trader can buy an asset cheaply in one market and simultaneously arrange to sell it at another market for a higher price. Since such opportunities are unlikely to exist for a long time and arbitrageurs would rush to buy the asset in the cheap location, the price gap will close very fast. For example, Reliance Ltd is traded at Rs. 1985 in NSE and at Rs. 2010 at BSE, an arbitrageurs can buy shares in NSE and sold it in BSE and pocket Rs. 25 per share. But this situation is very short term in nature.
Arbitrageurs also try to take the advantage of difference in prices which arises due to merger of two or more companies as we seen in Reliance and Future Group deal. But all the 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.