commodity market part -2

Products, participants and functions

Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories - hedgers, speculators, and arbitragers.

1.   Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.

2.   Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.

3.   Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.

Whether the underlying asset is a commodity or a financial asset, derivative markets performs a number of economic functions.

     Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices

Some commonly used derivatives

Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage.

Forwards: As we discussed, a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded.

Options: There are two types of options - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are :

•    Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

•    Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap