Derivatives are financial securities whose values are derived from an underlying asset or group of assets. Derivatives are contracts between two or more than two parties. Whenever there is a fluctuation in the price of the underlying asset, it affects the price of the derivative contract as well. These underlying assets can be stocks, indices, bonds, currencies or even commodities like silver, gold, crude oil etc.
Derivatives are traded on the stock exchanges and are also used by institutional investors for hedging risks and also to speculate the price changes in the value of the underlying asset. The derivatives which are traded on the exchanges are standardized and have lower risks compared to over the counter derivatives. Derivative instruments are leveraged instruments and thus have a high risk to reward ratio.
The participants in the derivatives market can be broadly categorized into the following four groups:
Hedging is when a person invests in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements. Derivatives are the most popular instruments in the sphere of hedging. It is because derivatives are effective in offsetting risk with their respective underlying assets.
Speculation is the most common market activity that participants of a financial market take part in. It is a risky activity that investors engage in. It involves the purchase of any financial instrument or an asset that an investor speculates to become significantly valuable in the future. Speculation is driven by the motive of potentially earning lucrative profits in the future.
Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of or profiting from the price volatility of the market. Arbitrageurs make a profit from the price difference arising in an investment of a financial instrument such as bonds, stocks, derivatives, etc.
- Margin traders
In the finance industry, margin is the collateral deposited by an investor investing in a financial instrument to the counterparty to cover the credit risk associated with the investment.