What is a Derivative? A Guide to Financial Derivatives

Investing in the stock market can feel overwhelming with so many options and constant price changes. One important instrument is a derivative, a contract whose value depends on the performance of an underlying asset like a stock, bond, or market index. Derivatives can be used to manage risk and seek profit, but they also carry a significant risk of loss.

So, what exactly is a derivative, and how does it work? This blog will explain everything you need to know, from the types of derivatives and how to trade them to their advantages and risks. Before we get into how derivatives work, it helps to understand what the term derivative means in the stock market.

Table of Contents:

• What is a Derivative?
• Types of Underlying Assets of Derivatives
• Types of Derivatives in the Market
• How Derivatives Work in Trading
• How to Trade Derivatives
• Advantages of Derivatives
• Disadvantages of Derivatives
• Real-Life Applications of Derivatives

What is a Derivative?

Derivatives are financial contracts whose value depends on the performance of an underlying asset or benchmark. 

These underlying assets can be physical (like commodities) or financial instruments such as indices, interest rates, or even other derivatives. Some of the most common ones are stocks, bonds, commodities, currencies, interest rates, and market indices. The price of these assets fluctuates rapidly, and because derivatives are based on them, investors can profit or incur losses by accurately predicting these price movements.

Derivatives can be traded privately between two parties (called over-the-counter or OTC) or on exchanges. Exchange-traded derivatives usually require a margin, a performance guarantee, rather than full payment for the underlying asset, while some OTC contracts may not involve margin. Margin requirements are specific to each derivative type and exchanges, and are updated regularly through a process called mark-to-market. 

Types of Underlying Assets of Derivatives

Derivatives are based on various underlying assets, each with its own characteristics. Here are some:

1. Stocks: Stocks are widely used as underlying assets, giving investors options to predict prices and control risks.

2. Bonds: Bonds and other debt instruments, such as interest rate futures, are also used as underlying assets.

3. Stock Market Index: This is an indicator of how the market is performing. Market indices are usually the underlying asset to such derivative instruments as index options and index futures.

4. Interest Rates: Interest rate derivatives, such as swaps and futures, are based on movements in benchmark interest rates. These help institutions manage risks from interest rate changes in both borrowing and lending.

5. Credit: Credit derivatives like credit default swaps (CDS) shift a defaulting borrower’s risk to another party in exchange for a fee. This allows investors or lenders to handle credit risk without owning the underlying debt.

6. Commodity: These are physical goods that can be traded on exchanges because they are interchangeable. Most commodities traded on exchanges are the same type and quality, but some commodities can differ in quality or grade. Examples include gold, silver, wheat, and other agricultural products. These are traded on platforms such as MCX and NCDEX in India.

7. Currency: Currency futures, options, and swaps are based on exchange rates of national currencies such as INR or USD. These are traded in the BSE, NSE, and the Metropolitan Stock Exchange in India.

Understanding the underlying assets shows why derivatives come in different forms. Here are the main types traded in markets.

Types of Derivatives in the Market

Derivatives in the stock market primarily include forwards, futures, options, and swaps. 

Here are the following:

1. Forwards

The forward contract is an agreement between two parties, a buyer and a seller, in which they have agreed to trade a certain asset at a fixed price on a specific future date. They trade over-the-counter (OTC) and carry counterparty risk, which is the possibility that one party may fail to fulfil their obligation. In case one party defaults, the other has limited recourse to cover losses.

Forward Contract Example:

For example, if you agree to sell 1,000 refrigerators to another company at Rs. 35,000 each in three months, the buyer will pay Rs. 3.5 crore at contract settlement. Until the settlement date, both parties face price risk; if the market price changes, one party may gain while the other party may incur a loss. 

2. Futures

A futures contract is an agreement to sell or purchase an underlying asset, such as a commodity, stock, or index, at an agreed price on a particular date. The parties have a duty to fulfill the contract. These are listed on stock exchanges, where there is standardization of rules and regulations, and minimization of the default risk. Moreover, the value of the futures contracts is also marked to market every day up to the date of expiry, i.e., the value of the contract is adjusted according to the market trends.

Futures Contract Example:

An iron and steel company buys a futures contract for 100 metric tons of coal at a fixed price of Rs. 5,000 per metric ton, with the contract expiring in six months. The iron and steel company is hedging against the risk of rising fuel costs.

If the market price of coal rises to Rs. 8,000 per metric ton, the iron and steel company is protected. It still purchases the coal for the agreed-upon price of Rs. 5,000, saving Rs. 3,000 per metric ton. 

On the other hand, if the market price falls to Rs. 3,000, the iron and steel company is still required to buy at the higher contract price. Although it misses potential savings, fuel costs are limited, managing its risk.

Thus, futures contracts let companies hedge against price fluctuations effectively.

3. Options

Option contracts entitle the buyer to purchase or sell an underlying asset at a specified price (strike price) at any time (until the expiration date). It works differently from other derivatives because the buyer has the right, but not the obligation, to buy or sell the asset, while the seller must fulfil the contract if the buyer chooses to exercise the option.

Options Derivative Examples:

• Call Option: Right to buy an asset at a set price within a period.
• Put Option: Right to sell an asset at a set price within a period.
• Equity Option: Based on individual stocks such as Reliance Industries.
• Index Option: Based on market indices like Nifty 50.
• Currency Option: Based on exchange rates, for example, INR/USD.
• Commodity Option: Based on commodities like silver or crude oil.

4. Swaps

Swap derivatives are agreements between two partners to exchange cash flows or instruments within a fixed term. These agreements help manage risk, improve cash flow, and enhance financial performance through the exchange of financial gains between parties. They are mostly over-the-counter and are not listed on stock exchange markets. There are two forms of swaps that are popular: currency swaps and interest rate swaps.

Swap Derivative Examples:

Suppose Company X has a loan with a fixed interest rate of 10%, while Company Y has a loan with a variable interest rate currently at 9%. Company X expects interest rates to drop, and Company Y prioritizes stability. 

Now, both companies enter into an interest rate swap agreement:

• Company X agrees to pay Company Y’s variable interest rate.
• Company Y agrees to pay Company X’s fixed interest rate of 10%.

If the variable rate drops to 6%, Company X will pay less interest to Company Y (6% instead of 10%), lowering its borrowing cost. Company Y, in return, gets a fixed rate of 10%, which gives it certainty and protects against rising rates. This represents how swaps can help companies handle interest rate exposure and stabilize cash flows.

Now that we have covered the main types, let’s see how traders actually use them in real markets.

How Derivatives Work in Trading

These contracts can be used to hedge the future price of assets such as stocks, bonds, gold, benchmarks, or currencies. In most derivatives, including futures, traders commit only a small fraction of a contract’s value, known as a margin, to control a larger position.

Futures and options are considered to be among the most traded derivatives. In futures, the two parties must stick to the agreement, whereas in options, the buyer is granted the right to purchase or sell the item but is not obliged to do so. There are other derivatives, such as forwards and swaps, which are also traded by institutions. 

How to Trade Derivatives

Now that we know what derivatives are and the main types, let’s see how people actually trade them. Trading derivatives takes planning, research, and care to handle risk. 

Here are the steps investors must follow:

Step 1: Open an online trading account

First, open an online trading account with a registered broker. You can trade derivatives either online or over the phone.

Step 2: Margin requirements

You must pay the initial margin, which is held as security until the contract is fulfilled or terminated. If your margin balance is lower than the minimum required amount, you will receive a margin call to top it up.

Step 3: Understand the asset

Thoroughly research the underlying asset and confirm that you have sufficient funds to cover margin requirements and other trading costs.

Step 4: Hold the investment

If you want to limit losses or lock in profits, you should hold your position until the trade is settled, unless you choose to close it earlier.

Derivatives can be useful, but they also come with risks investors should know about.

Advantages of Derivatives

Derivatives offer several advantages that make them attractive to investors. Here are some key benefits:

1. Risk Management (Hedging)

A derivative is one of the effective ways to protect against price fluctuations in underlying assets. It acts as insurance against potential losses.

2. Arbitrage Opportunities

They eliminate any mispricing between a derivative and its underlying asset. It allows buying an asset at a low price in one market and selling it at a higher price in another.  

3. Leverage

Derivatives allow investors to control larger positions with relatively smaller capital. Small price changes can quickly multiply profits and losses, and if the market moves against you, it can trigger a margin call. 

4. Lower Transaction Costs

Some derivatives have lower brokerage and statutory charges than trading the underlying assets, but this can vary depending on the market and type of derivative. 

5. Price Discovery

By reflecting expectations about future prices, derivatives help markets set fair values and guide investment choices.

Disadvantages of Derivatives

While derivatives offer risk management and arbitrage opportunities, they come with certain drawbacks that investors should be aware of.

1. Speculative Nature

Derivatives are often used for speculation, which can result in significant losses if predictions are incorrect. 

2. High Risk

Derivatives are highly volatile, which makes losses potentially fast and huge. 

3. Counterparty Risk

It is the risk that other parties can default on the contract, especially with OTC derivatives. Though exchanges minimize this risk for standardized contracts by functioning as intermediaries and needing margin deposits.

4. Liquidity Risk

Certain derivatives are difficult to quickly buy or sell without influencing their price, mainly in over-the-counter contracts. Closing a position can be significantly expensive or even impossible in certain market conditions. 

5. Complexity

The strategies behind derivatives involve complex factors that make them difficult for inexperienced investors to understand and trade effectively. 

Real-Life Applications of Derivatives

As we know, different derivatives serve different requirements. Forwards and futures often hedge price risk, while swaps manage cash flow uncertainties. Here are some examples of how these are applied in real life:

1. Exporters and currency exposure

Companies that earn in foreign currency use currency forwards or options to protect profits from exchange rate swings. For example, an Indian IT firm paid in US dollars might hedge against a weaker dollar using a USD-INR futures contract.

2. Investors and portfolio protection

Fund managers use index options to guard against market downturns. If they expect volatility, they might buy put options on the Nifty 50, a small cost that can offset losses if the market drops.

3. Banks and interest rate risk

Banks regularly use interest rate swaps to stabilize returns. If they have too many fixed-rate loans, they might swap some for variable-rate loans to match their liabilities and manage risk.

4. Agriculture

To lock in prices and protect against market volatility, farmers use commodity futures, for example, on crops like soybeans, rice, or wheat. 

Derivatives are used in many parts of finance, from exporters to investors. Understanding how they are used in real business decisions makes the concept far easier.

The Bottom Line

Derivatives are effective instruments for reducing risk and creating opportunities in the market. Organizations and traders use them to manage risk, speculate, and protect against price fluctuations. However, derivatives are also complicated and carry high risk. Start small to gain some experience before taking large positions.

What is a Derivative – FAQs