Learn about the participants of derivatives market – hedgers, arbitragers and speculators

Derivatives market participants are financial intermediaries that help maintain liquidity in the market. They also furnish depth to the market. We all are familiar with the features of financial markets. Through financial markets banks, corporate and government raise or deploy money to meet their requirements. The primary markets and secondary markets are two subcategories of the financial market. In the primary market, various financial intermediaries raise money by issuing instruments like shares, debentures bonds, etc. While in the secondary market you can do trading in these instruments. Means you can buy and sell these instruments issued in primary markets in the secondary market. The stock exchange like Bombay Stocks Exchange and National Stocks Exchange are the platform for such secondary market tradings.

The derivative market is a part of the secondary market. You can trade the future and option contracts of any underlying shares in a derivative market. Derivative market instruments are quite different in characteristics from instruments of other markets. These instruments basically help to minimize any risk that may arise from holding underlying assets. Let us now see what a derivatives market is and how it helps in minimizing the risk.

Derivatives market helps minimize risk

The origin of the word ‘Derivatives’ is from mathematics. Literally, a derivative is a variable that derives its value from another variable. Thus, a financial derivative is a product that derives its value from another financial product. We refer another financial product as the underlying in derivatives context. Hence, the derivatives market has no independent existence without an underlying commodity or asset. The price of the derivative instrument is contingent on the value of its underlying assets. The up and down movements in the market results in risk. And derivatives instruments help manage these risk in markets. The derivatives market empower investors to control their risk more efficiently and permit them to hedge or speculate on markets. Derivatives market participants use derivative instruments like future and options to manage their trading or investment risk in the market. The next section deals with such derivatives market participants.

Participants of the derivatives market

Generally, Banks, Corporates, Financial Institutions, Individuals, and Brokers are seen as regular participants to hedge, speculate or arbitrage in the markets. The participants can be classified into three categories based on the motives and strategies adopted.

1. Hedgers are the least risk lover in the derivatives market 

Hedging is an act, whereby an investor seeks to protect a position or anticipated position in the spot market. It is done by using an opposite position in derivatives. This means that if you have a buy position, you have to create a sell position and vice-versa. The parties who perform hedging are known as hedgers. In the process of hedging, parties such as individuals or companies owning or planning to own a cash commodity like corn, pepper, wheat, treasury, bonds, notes or bills, etc. are concerned that the cost of the commodity may change before either buying it in the cash market.

They want to reduce or limit the impact of such movements, which, if not covered, would incur a loss. In such a situation, the hedger achieves protection against changing prices by purchasing or selling futures contracts of the same type and quantity. You can achieve, such similar objectives by exercising options. In a situation when the prices of any of your underlying stock are intended to fall you can buy put options. Similarly, in situations with price rise, a call option is preferred.

2. Speculators in the derivatives market provide depth to the market 

Speculators are basically traders. They enter the futures and options contract, with a view to making the profit from the subsequent price movements. They do not have any risk to hedge. In fact, they operate at a high level of risk in anticipation of profits. Speculation provides liquidity in the market.

The speculators also perform a valuable economic function of feeding information. These pieces of information are not readily available elsewhere. They also help others in analyzing the derivatives markets.

3. Arbitragers as a derivatives market participants

Some traders participate in the market for obtaining risk-free profits. They do so by simultaneously buying and selling financial instruments like stocks futures in different markets. This process is known as ‘arbitrage’. Thus, ‘arbitrageurs’ are the person who does such kind of trading. For example, one can always sell a stock on the National Stock Exchange exchange and buy simultaneously back on the Bombay Stock Exchange platform.

The arbitrageurs continuously monitor various markets. And wherever there is a chance of arbitraging, they buy from one market and sell in the other market. In this way, they make a riskless profit. They keep the prices of derivatives and current underlying assets closely consistent and perform a valuable economic function.

Arbitragers and speculators perform almost a similar function. Since they both do not possess any risk to hedge for. They help in identifying inefficiencies that exist among the markets. It is also a fact that arbitragers help in price discovery of stocks. Further, this leads to market efficiency. On the other hand, speculators help in enhancing liquidity in the market.

About Author

Ankit Goyal

A Finance Professional with over 12 years of experience in Capital Markets & Investment Advisory. Ankit has worked with some of the largest & award winning financial services groups at Regional and National Level. Currently with RMoney, Ankit is a Specialist of Investment Advisory for Equity, Mutual Funds , Insurance, PMS , Fixed Income Products , Structured Products etc, I have managed both Retail, HNIs & Corporates business segments . Ankit loves writing on financial planning, equities, mutual funds & other investment products.