Have you ever wondered what derivatives are and how they work? If so, you are not alone. Derivatives are one of the world's most complex and fascinating financial instruments. They can help you hedge your risks, speculate on the future, arbitrage the market, and manage your portfolio. But they can also expose you to huge losses, legal disputes, and regulatory challenges.

Let’s understand the concept of derivatives in more detail.

What are derivatives?

A derivative is a contract whose value depends on an underlying asset or set of assets. The underlying asset can be anything, such as a stock, a bond, a commodity, a currency, an interest rate, an index, or even a weather condition. For example, a stock option is a derivative whose value depends on the price of a stock. A futures contract derivative is one whose value rests on the price of a commodity. A swap is a derivative whose value depends on the exchange of cash flows between the two parties.

Why are derivatives important?

Derivatives are essential for the following reasons.

• Hedge your risks: You can use derivatives to reduce or eliminate your exposure to an unwanted risk factor. For example, if you own a stock that pays dividends, you can use a put option to protect yourself from a drop in the stock price. If you have a loan that charges a variable interest rate, you can use a swap to fix your interest payments.
• Speculate on the future: You can use derivatives to profit from an expected change in the price or volatility of the underlying asset or market. For example, if you expect a stock to rise in the future, you can use a call option to buy the stock at a lower price. If you expect a commodity to become more volatile in the future, you can use a straddle to profit from both an increase and a decrease in the commodity price.
• Arbitrage the market: Derivatives help you to exploit a riskless profit opportunity arising from mispricing or inefficiency in the market. Consider the scenario where a stock is priced lower in one market than another. A futures contract allows you to profit by buying stocks in a cheaper market and selling them in a more expensive market.
• Manage your portfolio: Derivatives help adjust your portfolio's risk-return profile according to your preferences and goals. If your portfolio of stocks is too risky for your taste, you can use a collar to limit your downside risk and cap your upside potential. If your portfolio of bonds is too conservative for your taste, you can use a convertible bond to increase your exposure to the equity market.

How do you value derivatives?

The two most popular ways to arrive at derivative value are:

No-arbitrage pricing

This principle states that the price of a derivative must be consistent with the underlying asset's price and the risk-free interest rate. That means there should be no possibility of making a riskless profit by entering into a derivative contract and taking an offsetting position in the underlying asset or another derivative contract. If such an opportunity exists, arbitrageurs will exploit it until the prices adjust to eliminate the arbitrage.

Risk-neutral valuation

This valuation method states that the expected payoff of a derivative can be discounted at the risk-free rate to obtain its present value. This means that we can assume that the underlying asset follows a risk-neutral process, where the expected return is equal to the risk-free rate, and ignore the actual risk preferences of the market participants.

How to trade derivatives?

You can trade derivatives in two types of markets:

Over-the-Counter (OTC) market

The OTC market is a decentralised and informal market where derivatives are traded directly between two parties without the involvement of an intermediary or a clearing house. The OTC market is flexible and customisable, as the parties can work out the terms and conditions of the contract.

Exchange-Traded (ET) market

The ET market is a centralised and formal market where derivatives are traded on a regulated exchange involving an intermediary and a clearing house. The ET market is standardised and transparent, as the exchange specifies the terms and conditions of the contract.

Conclusion

Derivatives are financial instruments that help reduce risk, increase profit, exploit market inefficiencies, and tailor portfolios to specific needs. Their prices are determined by methods such as no-arbitrage pricing and risk-neutral valuation. Derivatives can be traded in two types of markets - OTC markets, which are decentralised and flexible, or exchange-traded markets, which are centralised and standardised.

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