Financial Matters - Derivative products & Participants

Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories - hedgers, speculators, and arbitragers.

1.Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.

2. Speculators: Speculators are participants who wish to bet on future movements in the price of an
asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of
money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.

3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit. Whether the underlying asset is a commodity or a financial asset, derivative markets performs a number of economic functions. _ Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

_ Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

_ Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for newentrepreneurial activity. Derivatives have a history of attracting many bright, creative, well educated
people with an entrepreneurial attitude. They often energize others to create new businesses, newproducts and new employment opportunities, the benefit of which are immense.

Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.