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Derivatives Market: Types, Features, and Functions

IndianMoney.com Research Team | Posted On Thursday, October 24,2019, 05:29 PM

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Derivatives Market: Types, Features, and Functions

 

 

What is the Derivatives Market?

Derivatives are tradable instruments that are based on other markets. So the derivatives market is based on any kind of other markets like stock markets, currency markets and stock indexes. There are several types of derivatives market consisting of thousands of individual derivatives that can be traded. So the derivates market is mainly investment markets where derivatives trading take place. In India, the available derivative instruments are currency, stocks, commodity and bonds. The BSC and the NSC are the two main exchanges that facilities the derivative trading.

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Derivatives Market in India:

The derivative market in India was introduced when the Bombay cotton trading association started future trading. Reports suggest that by 1900 India became the largest trading industry in futures.

However, the government of India imposed a ban on cash settlement and options trading in the year 1952. With the establishment of National Electronics Commodity Exchange, the ban on the commodities market was removed.

In 1993 BSC introduced the electronic-based trading system. However, forward trading started in its present form from the year 2001.

See Also: Commodity Derivatives Market in India

Types of Derivatives Market:

The Derivatives market is of several types. In some market, trading takes place in the usual manner while in some others the trading takes place quite differently. The following are the most traded types of derivatives market:

Futures Market: This is an auctions market where the investors buy and sell futures contracts or commodities for delivery on a future date. Here the trading takes place in the traditional manner, through open yelling and hand signals in a trading pit.

Options Market: Options are a contract that gives the right but it is not an obligation to sell the underlying at the stated date or price. These are other popular investment instruments in the derivatives market.

Features of Derivatives:

  • Derivatives have a maturity or expiry date post which they terminate automatically
  • Derivatives are of three types i.e. futures forwards and swaps and these assets can equity, commodities, foreign exchange or financial bearing assets.
  • All the transaction in the derivatives takes place in a future specified date. Doing this makes it easier to sell because an individual can take of markets and take the position accordingly because one has more time in derivatives.
  • A derivative can be used as leverage instruments. The value of the derivative can move exponentially in comparison to the value of its underlying.
  • There are no specified limits on the number of units that can be transacted in the derivative market as there are no physical assets for transactions.
  • The derivatives market is liquid and thus the transaction can be effected easily.

See Also: Understand Options and Futures

Functions of the Derivative Market:

Risk Management: the prices of the derivates are related to underlying assets. Thus any change in the prices of these assets will affect the derivatives market. Also, the derivates cannot be used to increase or decrease the risk of owning an asset. For example, to reduce the risk you may choose to purchase a spot item and sell a futures contract. If the spot price falls, the corresponding futures or options contract will be affected. You can then repurchase the contract at a lesser price which will result in a gain. This will help you to partially recover the loss on the spot item.

Price discovery: the derivatives market works as a key source of information about prices. The prices of the derivative instruments can be used to determine what the market expects the futures spot prices to be. Most often the future and the forwards market are used as a price discovery mechanism.

Operational advantage: the derivatives market is more liquid than the spot market. So the transaction costs are lower in this market. Other related costs like commissions are also lower than the spot market.

The derivatives market is much more efficient on account of risk management, short-selling, price discovery and liquidity.

See Also: What Is Financial Market?

How to Trade in the Derivatives Market:

  • As an investor, you must understand the functioning of the derivatives market before trading
  • The stock market strategies cannot be applied in the derivatives market.
  • You have to deposit a margin amount before you start trading here. You cannot withdraw the margin amount until the trade is settled. You also need to make additional payments if this amount falls below the minimum level.
  • To start trading you must have an active trading account. If you are buying through a broker then you have to place your order on phone or online.
  • For the selection of stocks, consider various factors like cash in hand, price of the contract, price of underlying shares.

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