Last updated on March 3rd, 2022 at 10:10 am
Yearning for a career in the capital market but do not know where to start? To flourish in your career, you will need to have a thorough understanding of derivatives.
Imarticus Learning has come up with a Financial Services and Capital Markets course to help such aspirants choose this career path. This article will help you grasp the basic concept of derivatives and how it works in the capital market.
What are Derivatives?
A derivative acts as an agreement or contract between two or more parties, the value of which depends on the agreed-upon underlying security, index, or financial asset. The parties make use of a derivative to assume risk with the anticipation of a proportionate dividend (speculation) or to mitigate risk (hedging). Some commonly used derivatives in the financial market are swaps, forward contracts, warrants, futures contracts, and equity or stock options.
A Comprehensive Understanding of Derivatives
Generally deemed as advanced investing, derivatives are secondary securities whose value is entirely based on the worth of the underlying primary security they are linked to. Even though the value of a derivative depends wholly on the underlying security, owning it does not necessarily mean the ownership of the asset. There are mainly two classes of derivative products - Lock and Option.
- Lock Derivative: The respective parties are bound by these products from the outset for the lifetime of the contract in accordance with the agreed-upon terms. Some commonly used lock derivative products are future contracts, swaps, and forward contracts.
- Option Derivative: These products offer the legal holder the right to buy or sell the underlying security or assets at an exact price before the expiration date of the option. However, the owner is not obligated to purchase or sell off if they do not wish to do so. Some commonly used options of derivative products are equity and stock options.
Benefits of Derivatives
Now that you have a basic understanding of the different classes and types of derivative products, it is critical to comprehend how they work. While derivates offer substantial benefits in the capitals market, the products work in a fairly complex manner. To get a more straightforward understanding of the various benefits and their working mechanics, you can take the example of any small-scale farmer.
A tomato farmer is worried about the fluctuating prices in the vegetable market due to inflation and the global pandemic. He wants to protect his business and contacts an investor. The investor decided to pay him at a rate of INR 30/kg of tomato in 6 months when the yield is ready.
- Hedging - By entering into this futures contract, the farmer immunizes his business from price fluctuations in the market. If inflation causes the price to fall below INR 30/kg, then the farmer is protected. But if the price rises to INR 50/kg, then he stands to miss out on the profit earned by the investor instead. Note that none of the parties is speculating on the price of the commodity, but the hedge is the way for each party to manage the risk.
- Derivative swap - Consider that the farmer has prospered and bought all the neighboring tomato farms through a massive variable-rate loan. But when he decides to expand more and contacts another investment firm, the investor refuses to cite his variable-rate loan. The farmer then contacts another friend who has a fixed-rate loan but wants a variable-rate loan in the hope that future interest rates will fall. Both draw up contracts where their respective loan payments get swapped but the names on the loan papers do not change.
Conclusion
There are other benefits available also such as credit derivatives and options contracts. Hence, to have a desirable career in the capital market, you can take relevant courses from Imarticus Learning to get a capital market certification. It will also give you a comprehensive understanding of derivatives, which will help you prosper more in your career.
