Derivative Market For Beginners.

Derivative Market For Beginners.

What Is Derivative Market?
What is derivative

Lately we have been hearing about this enormous market and derivative threatens to drag the whole financial system down, so the question arises well what exactly is this derivative that everyone’s talking about. Derivative in its essence is a very simple concept but the downside might be that it sort of encompasses this enormous world of financial instruments so each derivative is kind of slightly different although it has a single binding element that makes it similar.

 

Let’s dive into the meaning of derivative as its name suggests, is something that derives its value from its underlying assets. Let me make it more clear with an example, let’s take a friend named Jack. He wanted to put down the S500 deposit a few months ago to join the waiting list to buy a limited edition watch to be released 9 months later. Lots of other people similar to him did the same because of which the waiting list quickly closed. The Company has allocated all the watches which were to be produced in that batch for 2 years. So all Jack had to do was wait and then pay the rest of the purchase price when the watch was ready for delivery.

 

Recently he said he lost interest in buying the watch and decided he doesn’t want to make a further payment and asked with the agency where he deposited $500 as a booking amount, regarding policy about the company for such situation, the company’s representative said he can leave the right to purchase but he will not get a refund of the initially deposited amount. Now that he’s in the queue, paid deposit amount and doesn’t want the watch, what does he do?

 

The answer is simple; he has two options, he either has to leave the $500 which he paid as a deposit and not make further payment, or he needs to find someone who couldn’t book that watch while it was open for booking and give his place in the queue to them, in which case he could ask for the deposited amount. What he did was he had a conversation with a guy interested in getting his hands on one of these limited edition watches. He said to that guy, well I’ve got a place in the queue for the limited edition watch and I lost interest in it and willing to give it to you. He also said he paid $750 for booking it and he is ready to transfer that to the guy if the guy offers to pay that amount to him.

 

 

Derivative Contract

 

In this deal, Jack made $250 apart from his initial deposit and another guy got the right to receive limited edition watch which he was crazily waiting to buy.  If it was not for Jack, the guy wouldn’t have owned that, so Jack & the guy in this process has done a deal which is a derivative contract. This is a derivative contract which they agreed upon, where the delivery of the product is months away, is roughly a call option(more details about those on the following posts). You can see how easily derivatives get created and used by people without even knowing they’re using them.

 

It’s often the buzzword that falls, as people when they turn to financial markets and think, well this must be a very complex type of instrument, “I’m never getting my head around this concept” and to some extent this might be true as they are conceptual. It is always very good to remember that they are just a contract whose value is based on an underlying something. Let us take our above example of Jack in this, that underlying something is the limited edition watch, bring that concept to financial markets and that underlying something could be anything related to the financial market, just to name some they could be shares of any company, real estate or property of anybody, commodities like gold, etc. Therefore, the derivatives market is so big and so exciting because almost anything can form the underlying something for the contract. It is always essential to remember that a derivative in itself is not a product, it’s not the watch, it’s the contract of selling the right to own that limited edition watch between Jack and the guy that is derivative which derived its value from an agreement between them.

 

 

How Derivative Market Works

 

How Derivative Market Works?

 

By now you might be confident about what derivatives are, now let’s dive into How they work. Let’s continue with the above example of our dear friend Jack. In this scenario, let’s assume he didn’t talk to the guy about selling his right to own the limited edition watch instead he came to know about some platform where they buy and sell such rights. He then opened the account over there and came to know that the price of that limited edition watch once launched will rise in value due to its high demand and there was someone who agreed to buy the right at a premium of $500 and the watch was about to be ready for delivery in next month. He then thought why do I sell this right just for a profit of 500$ let me put a selling price of $1100 and to his surprise, someone bought that right at $1100 after 3 days. Let’s bring this same to the financial market with the watch being a stock of ABC company who is about to publish its report and declare dividend next month and there are two types of thinking about the upcoming reports of that company, one thought was the result will be bad(1st party) and the another was result will be good(2nd party). The spot price of that company is $20 and the investors of this company who are expecting positive result wants to hold more interest in the company and earn more dividend so they asked other investors who are expecting the bad result to sell their shares at a premium of $1 to them which is for $21.

 

The Investors who are expecting bad results of the company thought that if the company published bad report and price comes down they have to sell at a lower price so they decided to sell the right to own share of that company at the announcement date if 2nd party is willing to pay a premium of 2$ per share which is $22. They agreed to this and signed a contract, after this, there came a rumor that the company will be paying a handsome dividend this year and many investors are buying the share of that company due to which price of the company started to rise and before one week of the announcement the spot price reached $30. On the announcement day, the company announced a good dividend of 15%, and the price was closed at $31 so the 2nd party got a profit of $9 per share with this trade because they have a contract to own that companies share for $22. If the scenario was opposite and the price closed at $15 1st party would have gained a profit of $7 per share and 2nd party would have suffered the loss.

 

 

Why & When Derivative Market Started

 

Why Derivative Market?

 

This was a very basic example of how derivative market works we will dive deeper into these in coming posts. Does the above example of the stock market created any confusion about why 1st party agreed to enter into such a contract where they made a loss of 9$ per share? Derivative instruments are used for 2 purposes.

 

 

Hedge Funds

 

Firstly, this is because of the inherent fact associated with any market which is “uncertainty” so to minimize risk and hedge against possible downturn they agreed to enter into such a contract. The derivatives market and trading were made basically as a hedge instrument by the financial market participant. As per Mishkin 2006, p.309 Starting in the 1970s and increasingly in the 1980s and 90s, the world became a riskier place for the financial institutions. Swings in interest rates widened, and the bond and stock markets went through some episodes of increased volatility. As a result of these developments, managers of financial institutions became more concerned with reducing the risk their institutions faced. Given the greater demand for risk reduction, the process of financial innovation came to the rescue by producing new financial instruments that helped financial institution managers manage risk better. These instruments, called derivatives, have payoffs that are linked to previously issued securities and are extremely useful risk reduction tools.

 

 

Speculation

 

Secondly, derivatives are used as speculation. Speculation is fundamentally different from hedging, where the first ones are trying to reduce their risk exposure and usually are not motivated by profit in the derivative market itself. Speculators are motivated purely by profit. To put in other words hedgers use derivative markets as insurance policies against possible damages while speculators use derivative markets as pure profit-making instruments.

 

Types of Derivative Markets :

 

You might be considering it’s a massive market with endless possibilities so we can create infinite types of derivative markets, but there are only four main markets in existence

 

  1. Forwards
  2. Futures
  3. Options
  4. Swaps

 

We will dive deeper into these topics in future posts I will provide a basic overview in this post.

 

Forward Contracts:

 

As the name suggests forward contract is the customized contract between two parties to buy or sell an asset at a specified price at a specified future date in our example the contract to buy and sell shares at $22 at the date of the announcement. They are not traded on an exchange and as a result they’re particularly useful for hedging only.

 

Futures:

 

The future is a contract that simply tracks the price of an underlying asset without you having to bother about ever owning the underlying asset. You should not worry about storing tons of oil and coffee and so on. To get a hands-on futures trading it is easiest to start spread bet or a CFD contract(These Will Also Be Explained in Future Posts). Futures can also be understood as an exchange-traded version of a forward which is standardized and regulated so they can be used as a speculative derivative instrument.

 

Options:

 

Options are one of the popular and appealing among other types of derivative because it is something that gives you the choice at the end of the day about whether you buy or sell an underlying asset. Because it offers right without the obligation to honor the contract, you pay an upfront premium. There are many variety of options you find in the market which will be discussed in great depth in upcoming posts as this post is becoming long and monotonous to read and follow along.

 

Swaps:

 

wap is fairly self-explanatory and refers to the exchange of one security for another based on different factors. As defined in Investopedia “The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts primarily between businesses or financial institutions that are customized to the needs of both parties”.

 

 

To Be Continued……

 

This brings us to the end of this post I tried to make this post short as much as possible so that you don’t feel monotonous while reading the concepts and could follow along, this is the reason I have escaped many things, so don’t worry I will cover every concept in detail without making it cumbersome to read in future posts. As always show some love and if this post helped you like my Facebook page or drop a comment here if you have any confusion or things that could provide more knowledge to users and me as well. Also, remember to share and spread the word, this keeps me motivated to bring more informational content like this in the future.