MODULE-3
DERIVATIVES AND COMMODITY
MARKETS
• Introduction to Derivatives:
• The term Derivative indicates that instrument has no independent value of underlying asset.
Its value is entirely derived from the underlying asset which can be
• Securities
• Bullion
• Currency
• Live Stock,
• Or
• Anything else
• In other words, derivatives mean a forward, future, option or any other contract of pre—
determined fixed duration, linked for the purpose of contract fulfilment to the value of a
specified real or financial asset or to an index of securities.
• What are Derivatives?
• Derivatives are financial contracts whose value is linked
to the value of an underlying asset. They are complex
financial instruments that are used for various purposes,
including speculation, hedging and getting access to
additional assets or markets.
• Derivatives are powerful financial contracts whose value is
linked to the value or performance of an underlying asset or
instrument and take the form of simple and more complicated
versions of options, futures, forwards and swaps.
• Users of derivatives include hedgers, arbitrageurs,
speculators and margin traders.
• Derivatives are traded over-the-counter bilaterally between
two counterparties but are also traded on exchanges.
Forward and futures contracts are derivatives arrangements that involve two parties who agree to buy or sell a
specific asset at a set price by a certain date in the future. Buyers and sellers can mitigate the risks associated
with price movements down the road by locking in the purchase/sale price in advance
A forward contract is an arrangement that is made over-the-counter (OTC) and settles just once at the end of
the contract. Both parties involved in the agreement negotiate the exact terms of the contract. It is privately
negotiated and comes with a degree of default risk since the counterparty is responsible for remitting
payment.
Futures Contracts
• Futures contracts, on the other hand, are standardized
contracts that trade on stock exchanges. As such, they
are settled on a daily basis. These arrangements come
with fixed maturity dates and uniform terms. There is very
little risk with futures, as they guarantee payment on the
agreed-upon date.
• What Is a Futures Contract?
• A futures contract is a legal agreement to buy or sell a particular commodity
asset, or security at a predetermined price at a specified time in the future.
Futures contracts are standardized for quality and quantity to facilitate
trading on a futures exchange.
• The buyer of a futures contract is taking on the obligation to buy and
receive the underlying asset when the futures contract expires. The seller
of the futures contract is taking on the obligation to provide and deliver the
underlying asset at the expiration date.
• Swaps in finance involve a contract between two or
more parties on a derivative contract which involves
an exchange of cash flow based on a predetermined
notional principal amount, which usually includes
interest rate swaps which is the exchange of floating
rate interest with a fixed rate of interest and the
currency swaps which is the exchange of fixed
currency rate of one country with floating currency
rate of another country etc.
• Under the Swaps agreement, one party exchanges fixed cash flows in
return for floating cash flows exchanged by the other counterparty. The
most common kind of swaps in finance is Interest rates and Currency
Swaps.
• "Swaps" refer to derivative contracts where two or more parties
exchange cash flows based on a predetermined principal amount.
• This category encompasses interest rate swaps, involving
replacing a floating interest rate with a fixed rate, and currency
swaps, replacing a fixed currency rate from one country with a
floating rate from another.
• The financial industry offers diverse swap types, covering commodities, currencies,
volatility, debt, puttable swaptions, credit default, and more. Swaps serve as versatile
tools for risk management and financial optimization.
• What is the purpose of Derivatives?
• Derivatives are primarily used for hedging and speculation purposes.
.Hedging
To put it very simply for you, hedging means taking a
position to limit your losses due to price fluctuations in the
market. As derivatives are considered to be high-risk
instruments, hedging plays an important role in
minimizing the losses by taking an opposite position. This
proves to be a good cushion for both investors and
businesses to protect their portfolios during volatility.
Speculating
• We all speculate about certain things on a daily basis. For instance,
if you observe cloudy weather, you speculate that it will rain
soon and hence carry an umbrella. Similarly, in the derivatives
market, if you think the markets might go up and take a position
accordingly then you are speculating. Speculating purely involves
taking a position based on your views about an asset with an
intent to generate profit. These are usually hunches or guesses
based on the price movement. Unlike hedgers who try to minimize
their risk, speculators try to make profits by taking a high risk.
Arbitrage
• The main aim of arbitrage is to earn profits from the
difference in the price of an asset in different market
segments. It involves buying an asset from a market (say
spot market) where the price is lower and simultaneously
selling it on another market (say futures market) where it
is trading at a higher price. Arbitrage involves relatively low
risk. However, due to market efficiency theory, such
opportunities can be hard to find.
Commodity prices play an important role in the global economy as they influence the prices of
essential raw materials in the products used in our day-to-day lives, impact businesses, and
consumers.
Commodities can be bought and sold in the commodity exchanges, similar to trading stocks in
the stock market.
The commodity prices, however, are greatly influenced by the supply and demand of the
commodities in question.
Any change in the supply or demand of a commodity impacts its prices. On the other hand,
financial asset prices are driven by factors such as company earnings, interest rates, and investor
sentiment.
Commodity prices are mainly categorised into two types - Spot Price and Futures Price. Let us
understand their significance in detail and how they are different.
Benefits of Investment in Commodity
Potential Returns
There are factors which make the prices of individual commodity
fluctuate such as supply and demand, inflation and the overall
health of the economy.
In the past few years, demand has increased due to massive
global infrastructure projects in turn influencing commodity
prices. The related industries have observed a rise in commodity
prices because of the positive impact on the company stocks.