Derivative Market is that market where financial instruments such as future and options are derived from other forms of assets. This market can be divided into two types first one is Exchange-traded derivative and the second one is over the counter derivative these two have different nature and different forms of trading though traders are active in trading in both of these there are four types of traders in share market derivatives according to their trading motives which are Hedgers, Speculators, Margin Traders, Arbitrageurs.
Exchanges for future contracts are done in standardized derivative contracts which are futures and options containing a wide number of underlying products members in these contracts hold positions in these contracts with exchange which acts as a counterpart. In this when one is holding the position long the other one sells in short in this way the position of the contract is zero which is newly introduced therefore the sum of all long positions must be equal to the sum of all short positions in different words we can say that risk is transferred from one to another.
Derivatives are used in the following ways:-
- To mitigate the risk of underlying through entering into a derivative contract whose value moves in the opposite direction.
- Create an ability of option where the derivative value is attached to some condition.
- Get exposure where it is not possible such as weather derivatives.
- Give leverage so that small movement in the underlying value can cause a large difference in the value of a derivative.
- Make profit of the value of the asset moves the way expected.
Derivatives are traded in two ways first one is over the counter which are the contracts which are traded between two parties without an exchange or other intermediary products are traded such as swaps, forward rate agreements etc are almost traded in this way over the counter derivative is the largest market for the trading of derivatives. Second one is Exchange-traded derivatives which are traded through a derivative exchange this is a market where investors or individual traders trade in a standardized contract that has been defined by the exchange this exchange acts as an intermediary for all the related transactions and takes initial margin from both the sides of the trade to act as a guarantee.
Some common contracts in the derivative market are forward in which trading is done at a specific time and is carried up to a future date but at the price decided earlier, the second one is future contract to buy and sell an asset at a future date at a price specified today. The third one is an option which provides the owner the right but not the obligation to buy or sell an asset.
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