Financial Derivatives: Introduction, Types & Importance

By: Watsala Shakya

Introduction

Financial derivatives is technically a contract between two or more parties in which the involved parties value the contract on the basis of an underlying asset. In simpler words, it is a bet two or more parties make between them to avoid any confusion and disagreements regarding underlying assets in the near future. In these contracts, the underlying assets can be foreign currency, interest rates, units of shares, a commodity, or even an asset. For instance, if the involved parties disagree on what the price or value of the Australian dollar will be in 6 weeks, they can form a derivative contract to rid of the disagreement. The parties can fix a value so that if the value does not meet the expectations, anyone or all parties due to fluctuation in the price of the underlying asset.

A derivative is usually used to hedge against risk in a market and in transactions. The contract provides a certain level of assurance regarding the future. While a derivative is a rather complex financial security, it is used by traders to enter markets and to trade various kinds of assets. When entering a market, the newly entered trader has many areas to explore and access. They can use derivatives to hedge a position and to speculate the movement of the underlying asset. Financial derivatives are usually traded at exchange platforms or over-the-counter (OTC). Here, OTC means trading securities through a broker-dealer network instead of trading on a centralized exchange such as NEPSE or NYSE. However, the OTC market in Nepal is rarely used.

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Types of Financial Derivatives

Derivatives have a wide range of uses in various kinds of transactions. There are many types of derivatives that can be used for different purposes from risk management, gaining a position to speculating. Due to its wide variety of uses, it offers a range of products to match numerous risks as a result, the derivatives market is growing at breakneck speed. Within the rapidly growing derivatives market the derivatives financial derivative contracts we find are:

1. Option

Options are the type of derivatives that give buyers a special advantage, or a sort of priority. In this type of derivative contract, the buyer has the right to buy or sell underlying assets at a specific price at that specified period of time, which is known as the ‘strike price’. The option seller on the other hand is obligated to sell or buy the underlying asset at any moment the buyer wishes to buy or sell the underlying asset which is also known as ‘option writer’. For instance, if an investor wishes to purchase 1000 stocks of NIBL, which they predict will be worth Rs. 10 lakhs in the future stock market. The investor can offer to purchase the 1000 stocks at say Rs. 10,000 at present as an option buyer. The buyer will have the right to purchase the stock in the future, if luck sides with the buyer the price of stocks may increase which will give a profit, but if the price fall, the investor will face losses. However, different countries have different takes on this right or priority. In an American option, an investor can exercise the option contract at any time prior to the maturity of the option period. However, in the European option, the option can be exercised on the date of maturity.

2. Futures

Futures are the type of derivative contracts that allows concerned parties to buy or sell an underlying asset at a negotiated predetermined price at a specified date in the future. Under this form of derivative contract, the involved parties are under the obligation to fulfill the contract. Future contracts are traded in the stock market on the basis of the value of the future on a particular day, as the value of the futures contracts changes on a daily basis until the day the contract matures. For instance, an investor wished to purchase 100 liters of kerosene in the hopes that the price will increase from Rs. 110 per liter to Rs. 160 in the next 6 months. The investor hopes to sell kerosene at a profit after 6 months. So, in the future contract, the buyer and the seller would agree to buy and sell the 100 liters of kerosene at Rs. 110 per liter after 6 months on a predetermined date.

3. Forward

Forwards are derivative contracts similar to future contracts where the holding party of the underlying assets has the obligation to perform the contract. Forward contracts cannot be traded in stock exchanges and are unstandardized, however, they can be traded over-the-counter. A distinct characteristic of this derivative contract is that it can be customized to suit the requirements of the involved parties. Once a forward contract is made the involved parties can establish their positions. By doing so, they increase the potential for counterparty risk increases as more and more investors get involved in a single contract. Here, counterparty risk is a kind of credit risk in which involved parties may not be able to live up to the obligations mentioned in the contract.

4. Swap

Swaps are derivative contracts in which two parties exchange cash flow with one another. The cash flows are based on a principal amount as negotiated by the involved parties, which is based on a rate of exchange, without actually exchanging the actual principle. In swaps, one cash flow is usually fixed while the other changes on the basis of the interest rate. Swaps are not traded on stock exchanges, they are traded over-the-counter.

Importance of Financial Derivatives

To answer the question of financial derivatives are important we must look at various factors, not only from an investor’s point of view but rather from the perspective of the entire economy. The ways in which financial derivatives are necessary can be viewed from the following perspectives:

1. Risk management

Derivatives are important tools to hedge risk. Big fishes like banks and financial institutions (BFI), and the government are able to break down risks by trading to other investors using derivative contracts. The distribution of risks to investors by dividing the risk into smaller parts also helps to speculate. This actively demonstrates that derivatives identify the desired level of risk and compares it to the actual level of risk which assists to hedge and speculate.

2. Market efficiency

Arbitrage is a huge part of derivative trading. Economics defines arbitrage as a strategy of simultaneously purchasing and selling assets and commodities in different markets to take advantage of the different prevailing prices at different markets. The arbitrage ring price corrections in the economy which nudges the economy on the correct path of reflecting its true economic standing and its value. The market is thus brought to an equilibrium where the prices and the market are efficient.

3. Discovering prices

Derivatives assist in determining the correct price of commodities in the market. Derivatives are influenced by the environment, politics, and the economy around the assets or commodities which directly and indirectly affect the current and future prices of those assets or commodities. Futures and forwards in particular provide information regarding expected future prices and options which in turn reveal the volatility and risk associated with the price of the underlying asset or commodity.

4. Operational benefits

Derivatives play a vital role in keeping transaction costs in the market low. The cost of derivatives trading must be low and when this is done, subsequently the overall transaction cost in the economy is kept low. Derivatives also benefit investors and the economy by providing liquidity and encouraging short-selling.

Derivatives are the pillars of the financial structure of any economy around the globe. It provides leverage to markets and simultaneously adds volatility and risks to the market; in short, it influences the entire finance of the economy. It can be used as a tool to manipulate risks as the investor sees fit.

The Situation of Financial Derivatives in Nepal

The commodity derivative market has been introduced in Nepal, but unfortunately, it is yet to reach the level of expectations and popularity as expected when the Nepal Derivative Exchange (NDEX) was introduced. Investors have not been using the commodity derivative market as much as initial expectations. The reason for the failure of derivatives markets to make a mark could be the limited equity trading in the capital market.

The investors’ handbook on the securities market and commodity derivatives market published by Securities Board of Nepal (SEBON) mentions that under the provision of the Commodities Exchange Market, 2017, SEBON implements regulations regarding the issues and trade of commodities and assets while providing legal rights of investors. SEBON is also responsible to develop the derivatives markets for proper hedging, arbitrage, and speculation regarding the underlying assets. There had been three exchange companies that actively operated in the past which were Derivative and Commodity Exchange Nepal (DCX), Mercantile Exchange Nepal Limited (MEX), and Nepal Derivative Exchange Limited (NDEX) prior to the implementation of the Commodity Exchange Market Act, 2017. These exchange companies have contributed to the progress of the derivative market in Nepal, although the progress has been rather slow.

If the derivatives market and the commodity market broadened, investors would be presented with two alternatives for investment; investors could invest in either the equity market or the commodity market. If the equity market seemed to be functioning properly, investors would have the opportunity to invest in the commodity market and vice-versa. By doing so, investors would be able to mitigate their risk by diversifying their investment portfolio.

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