A derivative is a security or a contract whose value is derived from the performance of the underlying asset or assets. The value of the derivatives fluctuates with the fluctuations in the assets on whose performance the derivate is dependent. It is a contract between two parties on the basis of the assets. Common types of derivatives include stock, bonds, debentures etc.
The derivatives are categorized into two groups based on the way they are traded on the market:
Over the counter derivatives: Over the counter derivatives are those derivatives that are traded between two parties directly and private negotiating without going to any exchange or any other intermediary. Examples of such methods are Swap Method, forward rate agreements etc. As the derivative transactions take place in private; therefore no record can be maintained. They are still unaccounted for.
Exchange-traded derivatives: Exchange-traded derivatives are those derivative instruments which are traded via some specialized derivatives exchange or other exchange or any other intermediary. A derivative exchange is a place where the people can sell and buy listed derivatives. Every transaction taking place on the exchange is recorded. The world’s biggest derivatives exchange is the Korea Exchange which handles the largest number of transactions. According to the reports in 2007, the combined turnover of the whole world’s derivative exchanges was the US $681 Trillion.
A derivative market has several types of traders available in it. There are 4 main types of traders in any derivative market. These can be categorized on the basis of their motive in dealing in the derivative market. They can be categorized as follows:
Hedgers: Hedgers is the trader or a commodity producer who does trade in such a way that he sets off the potential losses or gains against the other commodity. In other words, he protects himself against price fluctuations in the commodity.
Speculators: Speculators are those traders that take higher than average risk on the commodities i.e. derivatives, stocks, debentures etc.
Margin Traders: Margin traders are the technique used to buy derivatives by borrowing money or funds from the broker. This method allows you to buy stock more than what you could have bought. For this, a person needs a margin account.
Arbitrageurs: An arbitrageur is a person in the market who tries to earn profit from the inefficiencies in the market by buying and selling different kinds of derivatives where loss from one derivative is offset from the profit on another derivative and capture risk-free derivatives.
The future markets always trade in the standardized derivative contracts. They take up the contracts on the basis of future contracts on a large range of underlying assets. In a future market, when one party goes long i.e. buys a future contract, the other party goes short i.e. sells the derivatives. This helps to maintain a balance in the market and the exchange.
Risk: The derivatives are a risky commodity to be traded. The derivatives can earn the investors a huge amount of profits by investing just a small amount in the assets. The investors can increase their worth manifolds using the derivatives. But these derivatives can incur hugely loses as well to the investor due to the use of leverages and borrowings. If the value of the underlying assets changes against the investor significantly, he will have to huge losses. The huge losses that occurred in the past amounted to as follows:
The loss of US$6.4 billion in the failed fund Amaranth Advisors,
The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998,
The loss of US$1.3 billion by Metallgesellschaft AG.
The loss of US$1.2 billion by Barings Bank.
Large Notional Value: The derivatives carry a huge amount of notional value. If the derivatives run into the loss, it will be a huge loss in the value. This huge loss can account to the economic crisis in the country. The problem with the derivatives is that they carry a larger notional value than the value of the underlying assets. The derivatives were created to transfer the risk and now it has become a risk itself.
Counter Party Risks: The derivatives impose high counterparty risks. Different derivatives have different levels of counterparty risks. They cannot be insured against such a risk. There is generally the highest risk in the Swap Derivatives. For example in the Standardized Derivatives, the parties are required to deposit some amount in the exchange so as to ensure that they can pay something in case of any loss. In case of the Over the Counter Exchange i.e. direct and private exchange, there is a higher risk as no preventive measures can be taken.
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