Role of derivative markets

By E.P.A. Sisira Kumara

What is a ‘derivative’? A derivative is a financial contract whose value is derived from or depends on the price of some underlying asset. Equivalently the value of a derivative changes when there is a change in the price of an underlying related asset.

In the markets for assets, purchases and sales require that the underlying goods or security be delivered either immediately or shortly thereafter. A payment is usually made immediately in these markets as cash markets or spot markets. The sale is made, the security is remitted, and the good or security is delivered.

In other situations, the goods or security is to be delivered at a later date. Still other types of arrangements let the buyer or seller choose whether or not to go through with the sale. These types of arrangements are conducted in derivative markets. In contrast to the market assets, derivative markets are the markets for contractual instruments whose performance is determined by how another instruments or asset performs.

In this article I referred to derivatives as a contract. Like all other contracts they are agreements between two parties, a buyer and seller, in which each party does something for the other.

These contracts have a price, and buyers try to buy as cheaply as possible, while sellers try to sell as dearly as possible.  The term ‘derivative’ is simply a new name for a tried and trusted set of risk management instruments. Unfortunately some financial market players or participants, not only the end users, but also some of the firms who provide a service in these instruments, have used these derivative products to speculative widely.

But it is better to understand the following statement when using the derivative products for different reasons by the market participants.

It says: “Derivatives have been linked to Aspirin: taken as prescribed for a headache, they will make the pain go away. If you take the whole bottle at once, you may kill yourself.”

There are various types of derivative products/contracts such as options, forwards contracts, futures contracts and swaps. It is interesting to understand the role of derivative markets. Following are few key roles of the derivative markets.

Role of derivative markets

1. Risk Management

2. Price discovery

3. Operational advantages

4. Market efficiency

Risk Management

As derivative prices are related to the underlying spot market goods (assets), they can be used to reduce or increase the risk of owing the spot items. For example, buying the spot item and selling a futures contract or call option reduces the investor’s risk. If the goods price falls, the price of the futures or options contract will also fall. The investor can then repurchase the contract at the lower price, affecting a gain that can at least partially offset the loss on the spot item. All investors however want/need to keep their investments at an acceptable risk level. Derivative markets enable those wishing to reduce their risk to transfer it to those wishing to increase it, whom we call speculators.

Because these markets are so effective at re-allocating risk among investors, no one need to assume an uncomfortable level of risk. Consequently investors are willing to supply more funds to the financial markets. This benefits the economy, because it enables more firms to raise capital and keeps the cost of that capital as low as possible.

Many investors prefer to speculate with derivatives rather than with the underlying securities. The ease with which speculation can be done using derivatives in turn makes it easier and less costly for hedgers.(hedge- a transaction in which an investors seeks to protect  a position or anticipated position in the spot market by using an opposite position in derivatives.)

Price discovery

Forward and futures markets are an important source of information about prices. Futures markets in particular are considered a primary means for determining the spot price of an asset. Futures and forwards prices also contain information about what people expect future spot prices to be. In most cases the futures price is more active hence, information taken from it is considered more reliable than spot market information.

Therefore futures and forward market are said to provide price discovery. Option markets do not directly provide forecasts of future spot prices. They do, however provide valuable information about the volatility and hence the risk of the underlying spot asset.

Operational advantages

Derivative markets offer several operational advantages, such as:

1. They entail lower transaction costs. This means that commission and other trading costs   lower for traders in these markets.

2. Derivative markets, particularly the futures and exchanges have greater liquidity than the spot markets.

3. The derivative markets allow investors to sell short more easily. Securities markets impose several restrictions designed to limit or discourage short if not applied   to derivative transactions. Consequently many investors sell short in these markets in lieu of selling short the underlying securities.

Market efficiently

Spot markets for securities probably would be efficient even if there were no derivative markets. There are important linkages among spot and derivative prices. The ease and low cost of transacting in these markets facilitate the arbitrage trading and rapid price adjustments that quickly eradicate these opportunities. Society benefits because the prices of the underlying goods more accurately reflect the goods true economic value.

Therefore the derivative markets provide a means of managing risk, discovering prices, reducing costs, improving liquidity, selling short and making the market more efficient.

(The writer is Senior Dealer – Money Market at People’s Bank Treasury Unit)