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Derivatives are the financial contracts or instruments, which derive their value from some other variables. In
short, these are the instruments whose value depends on underlying asset. The underlying asset can be equity,
index, commodity, bond or currency. Some of the examples of Derivatives are Forwards, Futures, Options and
Swaps.
Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the
underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples
of derivatives are Forwards, Futures, Options and Swaps.
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to
accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From
a market-oriented perspective, derivatives offer the free trading of financial risks.
Secondary market instruments: Derivatives are mostly secondary market instruments and have little usefulness in
mobilizing fresh capital by the corporate world, however, warrants and convertibles are exception in this respect.
Exposure to risk: Although in the market, the standardized, general and exchange-traded derivatives are being increasingly
evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in
existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be
uncertainty about the regulatory status of such derivatives.
Off balance sheet item: Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be
used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a
structured note whose coupon is tied to the performance of a particular currency pair.
What is the importance of derivatives?
Derivative is best used as risk management tool by which you can transfer the risk associated with the underlying
asset to the party who is willing to take that risk. To simplify the risk term, it has been divided into three parts:
There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional
instruments and transfer these risks to parties willing to bear these risks. The fundamental risks involved in
derivative business includes:
Credit Risk
Credit risk arises when any of the parties fail to fulfil the obligation under the agreement. Such an event
is called a default. It is also known as 'default risk'.
This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or
counterparty risk, it differs with different instruments.
Market Risk
Fluctuation in the prices of the underlying asset contributes to market risk. Market risk comprises of four risk
factors: Equity risk, Interest rate risk, Currency risk and Commodity risk.
Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying
asset/instrument.
Liquidity Risk
Liquidity risk is financial risk that arises due to uncertain cash crunch. An institution might lose liquidity if its
credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counter-parties to
avoid trading with or lending to the institution.
The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces
two types of liquidity risks
1.
2.
Legal Risk
Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked
into carefully.
1. Market risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole market.
Market risk is also referred to as systematic since it cannot be diversified away because the stock market as a whole may go
up or down from time to time.
2. Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government securities, and
bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price of fixed income
securities could fall if the interest rate shot up.
3. Exchange rate risk: In the case of imports, exports, foreign loans or investments, foreign currency is involved which gives
rise to exchange arte risk. To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have
emerged.
Forwards
Futures
Options
Swaps
Hedgers - Operators, who want to transfer a risk component of their portfolio. Hedgers are the end users
or producers of the particular asset or commodity who hedge against the price rise/fall risk.
Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Speculators are
the risk takers who want to benefit from the risk they take.
Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and
eliminate mis-pricing. Arbitrageurs usually earn profit by trading in two different markets
simultaneously or two instruments related to each other.