Why Do Derivative Markets Exist at All?

SYNOPSIS

Derivatives markets exist because prices never stay still. They help businesses and investors deal with uncertainty by transferring risk to those willing to take it. Through hedgers, speculators and arbitrageurs, these markets improve liquidity, support better planning and make it easier to navigate future price fluctuations.

When tomorrow’s prices are uncertain, derivatives become the bridge between risk and certainty, helping businesses survive and markets function smoothly.

A spot market only tells you today's price. But no business only thinks about today. A jeweller is not just worried about today's gold rate. He is worried about what gold will cost after three months, because he has already taken orders for the wedding season at today's price. An airline is not just looking at today's fuel cost. It has already sold tickets for flights that will fly six months later, at a price it decided today.

This is the gap that derivatives fill. Spot market tells you the price today. Derivatives help you plan for the price tomorrow.

A small example to understand it better

Take a company that has taken a loan on floating interest rate. Nobody knows for sure if rates will go up or down in future. If rates go up suddenly, the whole project cost can go out of budget. So the company enters into an interest rate swap and fixes its rate. Now it knows what it has to pay and it can plan its cash flow properly, instead of hoping and praying.

This is basically what derivatives are for. They do not remove the risk completely, because risk cannot just disappear. Somebody has to carry it. Derivatives only decide who will carry it, so that the people who cannot afford surprises can pass on that risk to people who are ready to take it.

So who takes this risk?

There are three types of people in this market and once you understand them, the whole picture becomes clear.

Hedgers are the ones who want protection. Our jeweller, our airline, an exporter who is worried the rupee will become weak before he gets his payment, an importer who is worried it will become strong, all these are hedgers. They are not trying to earn extra profit from price movement. They only want that price movement should not spoil their business plan.

Speculators are the ones who take a view on price and try to earn from it. Many people think speculation is same as gambling, but it is not fully correct. Without speculators, hedgers will often not find anyone to take the other side of their trade. If everybody only wants to reduce risk, then nobody is left to take that risk. So speculators are actually the reason hedging becomes possible and market stays liquid.

Arbitrageurs work quietly in background. They notice small price difference of same asset in two different markets and they trade on it till that difference closes. Because of them, prices in different markets stay in line with each other, even though most people never notice this happening.

But derivatives are not fully safe also

This does not mean derivatives have no risk. They are only as safe as the person using them properly. Leverage is what makes derivatives useful, but same leverage can also create big losses if used without understanding. Even a small unexpected price move can wipe out a position if it was taken with too much leverage. This is why exchanges and regulators have put margin requirements, daily mark to market and position limits, not to slow down the market, but to make sure one bad trade does not create problem for the whole system.

In simple words

Derivatives markets exist because future is uncertain and no business can just sit and wait to see what happens. Because of derivatives, a jeweller can take an order today without worrying about tomorrow's gold price. An airline can sell a ticket today without betting the whole company on crude oil price. A company can take a loan without worrying that one interest rate change will break its whole project.

Somebody has to bear this uncertainty. Derivatives only decide who.

Anshi Faria