Why do derivatives market exist?

As we saw in the introductory articles, derivatives are complex financial instruments and dealing with derivatives is often riskier than dealing with the underlying asset themselves. If they are so complex to deal with, then why do they exist? Why are so many interested in it? What purpose do they serve? We’ll try to find answer all this in this post.

Before that let me clarify a point. There is a common misconception that derivatives would bring  financial ruin. That’s not true. Derivatives by them selves do not bring in any additional risk to the economy. Improper handling of derivatives can cause damage – now, isn’t that true with anything we handle in life? So the root cause of any loss through derivatives is not the problem of derivatives.

Of course, the financial ruin of America started with the complex transactions on derivatives.. President Barack Obama recently said that he will veto legislation that does not bring the derivatives market under control so that he can assure that America does not have the same kind of crisis that they have seen in the past.

However, the problem was not with derivatives. The problem was with the people who used it in an uninformed and reckless manner.

DO WE REQUIRE DERIVATIVES?

Do we require derivatives?  The answer is –yes. Its required because of its advantages to the economy. Derivatives in any economy serve three basic functions:

  • 1. Price discovery
  • 2. Risk management
  • 3. Speculative activity

All the three functions are required for any economy to function properly.

PRICE DISCOVERY

Derivatives play a crucial role in discovering the present and future price of any commodity or financial asset. This is an essential part of an efficient economic system. Prices of stocks and commodities tend to move in the same direction as the expectations of market participants. Hence, the price in the futures market reveals the demand – supply expectation in the future and thus undertakes the process of price discovery in the spot market.

For example – take the case of a sugar manufacturer. He doesn’t know what could be the price of sugar two months down the lane. By closely following the futures market rates of sugar he would be in a position to figure out the future demand-supply relation of sugar and plan his production accordingly.

Or, take the case of jewelers in Mumbai and Delhi. Assets like gold may be sold for marginally different rates in  Mumbai and Delhi.Gold Derivative contracts on the NSE would have only one value and so traders in Mumbai and Delhi can validate the prices of spot markets in their respective location to see if it is cheap or expensive and trade accordingly.

RISK MANAGEMENT.

Organizations or individuals – financial uncertainties expose them to unexpected losses in many ways. Derivatives are instruments meant to cover risks. Corporates, traders and individuals use derivatives as a tool of risk management to cover the vagaries of price fluctuations.

For example:

Let’s assume that today is May 1st and you hold shares of reliance now trading at Rs 500. You expect the price of shares to come down in future. Reliance futures are available at Rs 525 right now. You can sell shares at Rs 525 and lock your profits. Should the spot price of reliance fall to Rs 375 as expected, you gain Rs 150 per share. In the normal case, you would have been sitting with a loss of Rs 125 per share.

The above process is technically called ‘Hedging’. ie,making an investment to offset the potential loss of another investment.

Let’s take another scenario. June 30 Reliance call options are available on the NSE at 500 strike. That means, buying that call will give you the right to buy reliance shares at 550. Now, at the end of June, if the share price remains at 550 or less than that, you will not exercise your right and will consider the amount paid to buy the option ( called premium) as loss.

That amount of premium is the maximum loss he would suffer. Hence, loss is always limited. On the other hand, if the share price of Reliance goes above Rs 550, ( say current market price is 600) the call will be exercised. You will buy the shares at 550 and sell it at 600 and make profit. You profit will be 50 (minus) premium paid.

The possibility of gain can be unlimited. Imagine the profit if the share price increased to 950 by the end of June. it would be 400 (950-550) less the premium paid. Assuming that the premium paid is 30, your profit would be –

*400-30 = 370 per share x number of shares in one lot.

So, derivatives help informed investors take advantage of favorable price movements.

SPECULATIVE ACTIVITY.

Speculators, due to their volume of activity, drives prices in one direction and then, in the other causing upward and downward movements in prices. What drives them is not fundamentals but mass sentiments. Irrational speculators may get lost in the process of speculation. But, rational speculators would jump in on any mispricings in the market and this results in the price being brought back to equilibrium. For example, if a speculator thinks that the price of a certain stock is over priced and hence may fall, he would immediately jump in and sell the stock. The masses follow the trend and that results in a huge sell off and thereby it brings the stock back to its actual worth. They also add liquidity to the markets. So speculative activity is required to maintain that balance.

You may like these posts:

  1. Types of derivatives 2 – Futures contract
  2. Types of derivatives 3 – Options contract
  3. Introduction to Derivatives.

1 Response to “Why do derivatives market exist?”

Basics of the stock marketing

March 16, 2012 at 6:12 am

Nice article Jins.

I do see many traders who simply do not understand the risks around derivatives get caught ‘with their pants down’.

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