Sometimes as an entrepreneur you must find different ways to increase the assets of your business; one of the ways your business’ assets can grow is by investing in the derivatives market. The derivatives market refers to the financial market for financial instruments, such as future contracts or options, that are based on the values of their underlying assets.
Who Normally Participates in the Derivatives Market?
Any business owner can participate in the derivatives market; nevertheless, the most common individuals who participate are (1) hedgers, (2) speculators, (3) arbitrageurs, and (4) margin traders.
Hedgers are individuals who invest in financial markets to reduce the risk of price volatility in exchange markets; for example, a hedger might do this to eliminate the risk of future price movements. Speculators are individuals who purchase a financial instrument or an asset that the investor speculates will increase in value significantly sometime in the future.
Arbitrageurs are those that take advantage of the price volatility of the market, and therefore profit from it. The process of arbitrage allows arbitrageurs to make a profit from the price difference coming from an investment of a financial instrument such as bonds, stocks, or derivatives. Lastly, margin traders invest in margins in the market; margins are the collateral deposited by an investor investing in a financial instrument to the counterparty to cover the credit risk associated with the investment.
What Are the Different Types of Derivative Contracts?
As a business owner, you have many types of derivatives to choose from, nevertheless, there are four that are the most common: (1) options, (2) futures, (3) forwards, and (4) swaps.
Options are a financial derivative contract that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (i.e., strike price) during a specific period of time. Futures are standardized contracts that allow the holder of the contract to buy or sell the respective underlying assets at an agreed price on a specific date. The parties involved in a future not only possess the right but also the obligation to carry out the contract, in contrast to options.
Forward contracts allow the investor to possess not only the right but also the obligation to carry out the contract. However, unlike futures that are traded in the market exchanged, forwards are not regulated and can be bought by the previous owner directly. Lastly, swaps involve two holders, or parties in the contract, who exchange financial obligations, such as interest rate swaps. Like forwards, these are not regulated and can be bought by the previous owner. Interest rate swaps, the most common form of swaps, is a type of derivative contract through which two parties agree to exchange one stream of future interest payment for another, based on a specified payment amount (called a principal).
What Are Some of the Criticisms of the Derivatives Market?
There are four main criticisms to the derivatives market. The first criticism is the high risk associated with trading in this form of financial instrument, as such it is usually recommended to investors who have a lot of experience in market trading. The second criticism is how highly volatile the market is, being sensitive to any small change from the expiration date to the interest rate. The third criticism is how overly complex it can become, sometimes becoming stressful to the untrained investors; as such, it is sometimes recommended for the untrained investor to hire a professional broker to help you through the process. The last criticism is that many people call this process “legalized gambling”, where you are allowing people to take high risks for sometimes low rewards.
