Derivatives are a very important financial instrument of the financial derivatives market as they help investors to hedge their risks, enable price discovery, and improve the liquidity of the underlying asset. There are different types of the derivatives market for derivative trading, namely; Options Derivatives, Future Derivatives, Index Derivatives. These financial derivatives are the financial contracts whose value is derived from their respective underlying asset. Further, there are various types of individuals with various investment goals to trade in the market, called Market Participants.
Market Participants in the derivative market take positions to earn riskless profits by taking two different positions in the same or different contracts.
Each type of individual will have an objective to participate in the derivative market. Derivatives market participants can be divided into the following categories based on their trading motives:
These are risk-averse traders in stock markets. Hedgers use derivatives, especially during market volatility. They aim at derivative markets to secure their investment portfolio against the market risk and price movements. They do this by assuming an opposite position in the derivatives market. In this way, they transfer the risk of loss to those others who are ready to take it (speculators). In return for the hedging available, they need to pay a premium to the risk-taker. This works in a way that - If you hold 100 shares of a company which is currently trading at a price of Rs.120. Your aim is to sell these shares after three months. However, you don’t want to make losses due to a fall in market price. At the same time, you don’t want to lose an opportunity to earn profits by selling them at a higher price in the future. In this situation, you can buy a put option by paying a nominal premium that will take care of both the above requirements.
Long Hedge: Long hedge is the transaction when we hedge our position in the cash market by going long in the futures market. For example, we expect to receive some funds in the future and want to invest the same amount in the securities market. We expect the market to go up in near future and bear the risk of acquiring the securities at a higher price. We can hedge by going long index futures today. On receipt of money, we may invest in the cash market and simultaneously unwind corresponding index futures positions.
Short Hedge: Short Hedge is a transaction when the hedge is accomplished by going short in the futures market. For instance, assume, we have a portfolio and want to liquidate in near future but we expect the prices to go down in near future. This may go against our plan and may result in a reduction in the portfolio value. To protect our portfolio’s value, today, we can short index futures of equivalent amounts. The amount of loss made in the cash market will be partly or fully compensated by the profits on our futures positions.
Cross Hedge: When a futures contract on an asset is not available, market participants look forward to an asset that is closely associated with their underlying and trades in the futures market of that closely associated asset, for hedging purposes. They may trade in futures in this asset to protect the value of their asset in the cash market. This is called a cross hedge. For instance, if a futures contract on jet fuel is not available in the international markets, then hedgers may use contracts available on other energy products like crude oil, heating oil, or gasoline due to their close association with jet fuel for hedging purposes. This is an example of the cross hedge. When we are using index futures to hedge against the market risk on a portfolio, we are essentially establishing a cross hedge because we are not using the exact underlying to hedge the risk against.
Speculators are the exact opposite of hedgers. These are the risk-takers of the market. Rather than protecting their portfolio, they aim at making higher gains in a shorter amount of time by taking risks in the derivatives market. Speculators take positions in the derivatives market without having a position in the underlying cash market. These positions are based upon their expectations of the price movement of the underlying assets.
When they expect the market to go up, they may take a long position in these futures and when they expect the market to go down, they may take a short position in single stock futures.
This difference of perception and thought process helps them to make huge profits if the bets turn correct. In the above example, you bought a put option to secure yourself from a fall in stock prices. So on the other hand i.e. the speculator will bet that the stock price won’t fall. If the stock prices don’t fall, then you won’t exercise your put option. Hence, the speculator keeps the premium and makes a profit
Arbitrageurs utilize low-risk market imperfections to make profits. They buy low-priced securities in one market and sell them at a higher price in another market at the same time. This is only possible when the same security is quoted at different prices in different markets. If an equity share is trading at Rs.1000 in the stock market and at Rs.1050 in the futures market. An arbitrageur would buy the stock at Rs 1000 in the stock market and sell it at Rs 1050 in the futures market. In this process, he/she earns a low-risk profit of Rs 50.
Cash and Carry Arbitrage: Cash and carry arbitrage refers to a long position in the cash or underlying market and a short position in the futures market.
Example: Data of Stock A.
The fair price of futures is 1510 (1500 + (1500*0.67%). Going by the theoretical price, we may say that futures on stock A are overvalued. To take advantage of the mispricing, an arbitrageur may buy 100 shares of stock A and sell 1 futures contract on that at given prices. This would result in an arbitrage profit of Rs. 1000 (= 100 X 10), which is the difference between actual and fair prices for 100 shares.
Reverse Cash and Carry Arbitrage: Reverse cash and carry arbitrage refers to a long position in the futures market and a short position in the underlying or cash market.
Example: Data of Stock A
Implementing this arbitrage opportunity means the arbitrager has got the stock to sell in the cash market, which will be bought back at the time of reversing the position
To execute the reverse cost and carry, the arbitrager would buy one future at Rs 90 and sell 200 shares of stock A at Rs 100 in the cash market. This would result in an arbitrage profit of Rs 2000 (200 X Rs 10).
Inter‐Exchange Arbitrage: This arbitrage has two positions on the same contract in two different markets/ exchanges.
If futures on stock Z is trading at Rs. 101 at NSE and Rs. 100 at BSE, the trader can buy a contract at BSE and sell at NSE. The positions could be reversed over a period of time when the difference between futures prices squeezes. This would be profitable to an arbitrageur. The cost of transactions and other incidental costs involved must be analyzed properly by the arbitragers before entering into the transaction.
The high-risk nature, sensitivity and volatility involved in this market makes it a complex market. But the main functions of it, like price discovery, transfer of risk, hedging and lower transaction cost makes it a popular financial instrument among traders.