What is a Derivative Market?

 Before, understanding what is Derivative Market? First, we have to know what is derivative? 

Table of Contents:

1) What is Derivative market?

2) Types of Derivative Contract?

In simple words Derivative means something which is not an innovation but derived from something which is exist earlier. For e.g. Curd and Buttermilk are the derivatives of milk, petrol and diesel are the derivatives of crude oil. The price of derivative is determined by price of base commodity. If price of milk rises the price of curd and buttermilk is also rises. 

Now, we understand, 

What is Derivative ?  

Derivative market

Derivative is the deal or contract in which the price is decided from the price of base commodity or assets. These assets may be anything. e.g. shares, index, gold, commodity etc. 

So, now we understand,  

What is Derivative market? 

As name suggest derivative market is the derivative of cash market. Cash market is refers to the stock market where the shares of the company are traded. In the derivative market the investors forecast the future share price of the companies and on that basis enter into different contracts. 

Types of Derivative market:

Basically, there are four types of derivative market:

1) Forward:

2) Future:

3) Options:

4) Swaps:

1) Forward Contract:

Forward contract is the contract between two parties to execute a transaction at current price in future. 

For e.g. Amit wants to buy 100g of Gold for her sister's wedding which is 3 months later. But, he is cautious because he believes that gold prices will rise in 3 months. So, he gone to meet a jeweler and convinced him to buy the Jewelleries at current price after 3 months. After, 3 months when Amit goes to the jewelry shop the jeweler denied to give him Jewelleries because of rise in price of gold. 

2) Future Contract:

Future Contract is the contract between two parties to execute the transaction at current price in future. Unlike, forward contract the future contract is regulated by stock exchange. The price, lot size and expiry of the contract is decided by stock exchange. Here, the buyers and sellers both have to pay the margins. Special feature of future contract that the parties can expire the contract at any time. 

There are certain difficulties in forward market to overcome that future market came in existence.

These difficulties are:

1) There is no regulated body between the two parties in forward contract. In forward contract the price and lot size is decided by the both parties. So, it is also called as 'Customizable Contract'. While, Future contracts are regulated by stock exchange. 

2) The risk of default by any party is involved in forward contract which is resolved by future contract. In future contract stock exchanges make sures that no party deafult the contract. 

3) To avoid default risk in future contract the stock exchange have made it mandatory for both parties to pay the margins. 

4) In forward contract to cancel the contract you have to convince the other party to cancel it. But, in future contract you can cancel the contract at any time. 

Types of Future Contract:

a) Stock Future contract:

In this contact one person promises to buy a particular stock in future at today's price and other person agreed to sell it. Both, the parties have to pay premium to stock exchange. 

b) Index Future Contract:

In this contact both parties deals in different index such as nifty, sensex, bank nifty etc. 

c) Currency Future Contract:

In this contract the the parties fix the prize of a currency in which another currency will be buy or sell in future. 

3) Option Contract:

Option contract is the contract between option buyer and option seller. Like future contract option contract is also governed by the stock exchange. In option contract, the buyer pays only premium to the seller which decided by the exchange. In option contract the loss of option buyer is extends to the premium paid by him and profit is unlimited. Where, the option seller gets only premium. 

4) Swap Contract:

Swap contract are very complex concept which is very difficult to understand. So, it is avoided by the small investors. 

In swap contract both the  parties where exchange the financial instruments for there assistance. Swap contract are not traded on stock exchange. They are traded at counter to customize the contract as per the Convinence and needs of the both parties. Interest Swap is the most popular type of swap contract in which investors like to enter in it. 

Why people invest in Derivative Market? 

There are basically two reasons for which people invest in derivative market. 

1) Hedging:

Hedging is done to secure the investment by avoiding the loss of short term price fluctuation. Hedging is not done for profit it is done to secure from losses. 

For e.g. You have 500 shares of Wipro Company whichs price is Rs 520 but you feels that in this month the share price of the company is going to fall, so you have short the 500 shares of Wipro company in derivative market. If the things is happened as you think then the share price will be fall in cash market do to which you have to suffered from losses. But, as you have already short the shares in derivative market you have earned same amount of profit. So, the loss of your is nill. 

2) Speculation:

People invest in derivative market for speculation purpose. They predict the future price of stocks to get the profit. Due to which it is also called as 'Legal Gambling' as it is similar to gambling. 

Difference between derivative market and cash market:

  • In cash market you must have to open a demat account but in derivative market you have to open a future & options account to trade in derivative market. 
  • In cash market you can buy the shares by paying full amount of shares (except Intraday trading), but in derivative market you can trade by paying only the margin or premium. 
  • In Cash market you can buy number of shares as per your own will but in derivative market the lot size is decided by the stock exchange. 
  • People invest in Cash market for long term investment purpose while in derivative market people invest for hedging or speculation purpose. 
  • People invest in Cash market for long term capital gain while in derivative market people invest for short term profit. 
  • In cash market, if a person buys a shares then he will become the owner of the company but it is not happen in derivative market. 
  • If a person buys the share in cash market he will be entitled for split, bonus, buyback and dividend if any announced by the company. But, it is not applicable to derivative market. 

Closing Thought:

Derivative market is good for hedging but it is risky. As No one can predict the market, it can be cause of big loss. 

We hope you like this article. If you have any query write in comment box we will reply you as soon as possible. 

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