Financial Derivatives: Functions, Risks, and Pricing
Derivatives are financial contracts whose value is derived from an underlying asset such as shares, commodities, currencies, or indices. Common derivatives include futures, forwards, options, and swaps.
Economic Significance of Derivatives
- Risk Management (Hedging): Derivatives help investors and companies protect themselves from price fluctuations and reduce financial risk.
- Price Discovery: They help determine future expected prices of securities through market demand and supply.
- Increase Market Efficiency: They improve market efficiency by ensuring the quick flow of information and reducing transaction costs.
- Liquidity Enhancement: Derivative trading increases trading volume and market liquidity.
- Speculation: Speculators use derivatives to earn profits from price changes, increasing market activity.
- Arbitrage Opportunities: Arbitrageurs use price differences between spot and futures markets to earn risk-free profit, helping correct market prices.
- Lower Transaction Cost: Derivatives require lower capital compared to the direct purchase of securities.
- Financial Market Development: Derivatives attract investors and contribute to the growth of financial markets.
Role of Derivatives in Stock Price Determination
- Reflect Future Expectations: Futures and option prices indicate market expectations about future stock prices.
- Faster Information Adjustment: Derivative markets quickly react to economic news and corporate announcements.
- Arbitrage Maintains Fair Prices: Arbitrage activities keep spot and futures prices aligned.
- Affects Demand and Supply: Derivative trading influences buying and selling pressure in stock markets.
- Measures Market Sentiment: Call and put options indicate bullish or bearish market expectations.
Advantages of Derivatives
- Help in risk management and hedging.
- Improve liquidity in financial markets.
- Assist in price discovery.
- Require lower investment due to leverage.
- Provide arbitrage opportunities.
- Increase market efficiency.
- Help in portfolio diversification.
- Support financial market growth.
Disadvantages of Derivatives
- High risk due to leverage.
- Excessive speculation may increase market volatility.
- Complex instruments difficult for ordinary investors.
- Possibility of unlimited losses in some positions.
- Counterparty risk in OTC contracts like forwards and swaps.
- Possibility of market manipulation.
- Can create financial instability if misused.
- Require continuous monitoring due to rapid price changes.
Understanding Options
An option is a derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. The seller of the option, however, has the obligation to fulfill the contract if the buyer exercises the option.
| Strategy | Market View |
|---|---|
| Long Call | Strong Bullish |
| Long Put | Strong Bearish |
| Covered Call | Stable/Slight Bullish |
| Protective Put | Protection from fall |
| Straddle | Huge movement uncertain |
| Strangle | Volatile market |
| Bull Spread | Moderate rise |
| Bear Spread | Moderate fall |
Meaning of Cost of Carry
Cost of carry refers to the total cost incurred in holding or carrying an underlying asset from the present date until the maturity date of a futures or forward contract.
Formula: Cost of Carry = Storage Cost + Interest Cost + Insurance Cost − Income Earned
The cost of carry model is used to determine the theoretical futures price.
Types of Cost of Carry Situations
- Positive Cost of Carry (Contango): When carrying costs are greater than income earned, the futures price becomes higher than the spot price.
- Negative Cost of Carry (Backwardation): When income earned is more than the carrying cost, the futures price becomes lower than the spot price (Futures Price < Spot Price).
Importance of Cost of Carry
- Helps in Pricing Futures Contracts: It helps in determining the fair value of futures and forward contracts.
- Creates Relationship Between Spot and Futures Market: Cost of carry links present prices with future prices.
- Useful for Arbitrage: Traders identify arbitrage opportunities when actual futures prices differ from theoretical prices.
- Important for Hedging Decisions: Investors and companies use cost of carry while making hedging strategies.
- Assists in Investment Decisions: It helps investors decide whether holding an asset is profitable or costly.
Advantages and Limitations
Advantages: Helps in proper valuation of derivatives, improves market efficiency, reduces mispricing in the futures market, and is useful for risk management.
Limitations: Difficult to estimate future costs accurately, interest rates may fluctuate, storage and insurance costs may vary, and market conditions can affect theoretical pricing.