One facet of the modern financial market is the market of financial derivatives. Financial derivatives is now one of the most important aspects of the market. Financial derivatives, particularly in the Indian Exchanges NSE, BSE, is one of the fastest growing segments in the last 20 years. Financial derivatives today is crucial for the functioning of all market stakeholders: traders, investors, financial institutions, companies. While in the beginning the notion of financial derivatives may appear difficult to grasp, the functions of financial derivatives are elementary for the functioning of the stock market in a stable, efficient, and growing manner. In this blog, I explain why financial derivatives are valuable and why they are important to all market participants.
To start, financial derivatives are simply contracts, and the value of a financial derivatives contract, depends on a certain underlying asset. That underlying asset could be equity shares of a company, commodity contracts, currencies, and certain financial market indices, like NIFTY, Bank NIFTY. In the equities market, common financial derivatives instruments are options and future contracts. Importantly, with options and future contracts, one does not need to own the underlying asset. rather, financial options and future contracts allow one to buy/sell at a future date with a pre-agreed price. This arrangement provides a mechanism for individuals to insure themselves against a loss, allow speculation of price estimates, and exploit inefficient pricing in the market.
A key reason derivatives are important is risk management, otherwise known as hedging. Long-term investors in stocks are constantly exposed to risk, as the market first reacts to the volatility and then to events such as economic announcements, geopolitical events, changes to interest rates, and news specific to the company. There are ways, however, through the use of derivatives, to protect a portfolio as a hedge, from sudden adverse price changes. For example, an investor with a very large holding of TCS shares may use a NIFTY or TCS option to hedge against potential loss exposure in the event of a market correction. For a small premium, the investor can buy a put option and obtain an insurance policy. Even large corporations such as mutual funds, insurance companies and foreign institutional investors (FIIs) use derivatives to hedge and protect risks which are in the range of multiple thousands of crores. This, in turn, provides confidence and reduces risk to investors.
Another key function of the derivative segment is price discovery. Derivatives such as futures and options contracts trade continuously and reflect the real-time expectations of market participants. For instance, reliance futures are trading at a premium to the spot price. This is a bullish market sentiment. So are NIFTY options, where a high level of put writing is observed, indicating a strong support level. This sentiment is useful to analysts, traders, and companies as it is a forward-looking indicator.
Next is the impact of derivatives on market efficiency. With the availability of futures and options contracts in the market, participants are able to take a position in the market with less capital and greater flexibility. The act of arbitraging, in which traders buy and sell between single cash and futures contracts, minimizes the opportunity to earn high profits in the market. For instance, in a cash market where reliance is slightly lower in price than the futures market, an arbitrageur purchases in the cash market and sells in the futures market, while pocketing a risk-free return. This causes market rates to converge, achieving price efficiency.
There is also an increase in market liquidity thanks to derivatives. For example, NIFTY and BANK NIFTY index derivatives are among the most popular and heavily traded financial products globally. Due to their high liquidity, market participants can easily enter and exit their positions. This draws in more people and keeps the market more dynamic and lively. Furthermore, liquidity benefits large institutions and active retail traders because market trading costs are lower and large orders can be executed more easily and seamlessly.
Retail traders love the high trading volumes associated with derivatives because of the trading leverage available. Forex and options contracts will only require a small percentage of the total value of the contract, which is known as the margin. This means that the trader can take a more significant position with a lower capital. For example, a trader buying shares in the cash market worth ₹1,00,000 will need to have that money available. However, in the derivatives market, only a 15% to 20% margin is required. It is important to keep in mind at this point that leverage can also increase the associated risk of the position, which can, in turn, lead to much more significant losses if the leverage is not managed in a manner that is prudent. Hence, discipline and a proper understanding of derivatives trading are required.
Also, goods are used for the diversification of portfolios. They allow traders to assume positions in the overall market through index future and options, rather than purchasing a series of individual stocks. Investors and businesses can protect themselves from the negative effects of changes in commodity prices and foreign exchange rates via currency and commodity derivatives. For instance, a USD exporter can hedge against currency depreciation via USD-INR future contracts. A company that relies on crude oil can hedge against the risk of increasing oil prices. This greater diversification not only adds value to market traders and businesses, but also the economy as a whole.
Another major function of derivatives is speculation. Although speculation is often frowned upon, it has an important function in the market ecosystem. Speculators assume particular risk depending on their forecasts and are important to increasing market liquidity, lessening the impact of market shocks, and aiding in the efficient discovery of prices. Speculators are important to hedge their risks.
In financial market growth as well, derivatives have an important contribution. The introduction of index derivatives in 2000 in India is a major pivot in the trading environment. Today, India is among the top countries in the world with a significant derivatives market. This attracts a variety of investors from different countries, enhances financial inclusion, and boosts the overall reliability of India’s stock market.Last of all, Derivatives have a unique contribution to stabilizing the markets. Derivative markets function as shock absorbers whenever there is a major economic event. There is increased hedging which calms down the cash market selling in times of a market panic. There are smart risks taken which are controllable by circuit breakers, margin requirements, and other rules set by SEBI.
The derivative segment is a unique and ever-growing segment of the stock market. It provides the market with the capabilities of managing risk, providing efficiency, creating liquidity, creating leverage, allowing for diversification, and creating efficiency in the market overall. The segment, like other parts of the market, provides great opportunities intertwined with a requirement of disciplined and intelligent use. Derivatives provide the individual and institutional market with a very smooth operation of the entire financial system, including the market.
