How do the Derivative Markets Function?

Derivative markets are unique kinds of markets where derivative instruments are traded. As we already know, derivative financial instruments are those financial instruments that derive their value from another underlying instrument such as stocks or bonds.

Futures, forwards, options, and swaps are some of the commonly traded derivative instruments. Derivatives markets have certain special features which make them different from other financial markets.

In this article, we will try to understand why derivative markets are important as well as the special features which make derivative markets different from the rest of the markets.

What Makes Derivative Markets Important?

From a financial system point of view, derivatives markets are extremely important. This is because they supplement other financial markets. The risks which become inevitable in other markets can be reduced or even eliminated in the derivatives market by hedging.

There are different types of participants in the derivatives markets. For instance, there are people who buy derivatives to hedge their risk. There are others who buy derivatives for purely speculative purpose. There are still others who buy and sell derivatives and act as arbitrageurs. Since there are so many different people with so many different motives, there is no shortage of counterparties in the derivatives market.

Types of Derivatives Markets

Like most other financial securities, derivatives are also sold in two different types of markets.

1. There are derivatives that can be bought and sold on securities exchanges. The exchange is the counterparty to every transaction in such cases.

2. On the other hand, derivatives can also be traded over the counter. In this case, the transaction happens directly between two parties, and counterparties like exchanges are not involved.

The notional values of derivatives traded in the world are over $6 trillion. This is more than the value of all the underlying securities in the world. This becomes possible because of the fact that derivatives are traded using margin trading. This margin trading is an important feature of the derivatives market.

How Margin Trading Works?

Margin trading is when the buyer of securities does not have to pay the entire amount of money upfront in order to buy securities. Instead, they can only pay a small percentage of the total value of the securities and take a position in the security.

This can be better explained with the help of an example. Suppose an investor wants to buy certain securities, the value of which is $100. The investor does not have to pay $100 upfront.

Instead, they can use the margin trading system. This means that they will only put a certain amount, let’s say $10 and will borrow the balance $90 from the broker. They will have to pay a nominal interest on these $90.

However, if the value of the security changes from $100 to $105, the additional $5 will become available in the account of the investor. Instead, if the value of this security goes down to $95, the investor will have to pay up the additional $5 in order to maintain the margin.

In simple words, the $10 paid by the investor is the margin. This margin is used to secure the interests of the people who have lent out the balance of $90. The investor has to pay additional money as and when this value goes down. This value needs to be maintained at $10 or any other value decided before borrowing funds.

Every time there is a shortage of funds, the broker sends out a call for additional funds. This is called a margin call. If the investor is not able to pay up within a specified amount of time, then the brokers have a right to sell off the asset, settle the account and repay the balance amount payable to the investor.

Time-Bound Nature of Derivative Contracts

Another important feature of the derivative markets is that it is time-bound. This means unlike equity and debt securities, derivatives cannot be held until infinity. As soon as a contract is drawn up, the expiration date is fixed.

At the expiration dates, the contracts are supposed to be settled. This settlement can happen in the form of cash or in the form of actual delivery of the underlying assets.

In most cases, the underlying assets do not change hand, and the contracts are settled by giving cash, which would enable the counterparty to buy the asset from the free market if they wish to do so.

This time-bound nature of the derivatives contracts makes them different as compared to other financial instruments. This is because people who buy equity or debt have the option to hold on to them infinitely until they think they are getting a good deal.

However, when a person enters into a derivative contract, they cannot hold on till infinity. That particular contract will expire on the expiration date. However, the investor can simultaneously enter into a different contract with an extended expiration date. This rollover feature practically allows the investors to hold on to derivative bets for longer periods of time.

To sum it up, derivatives markets are also important components of the financial market. They are significantly different as compared to the other markets. However, given their size and extensive usage, they can be considered to be as important as the other markets.