Question

The derivatives markets are viewed by some to be highly risky and equivalent to gambling. Explain your answers. Why is this an inaccurate description of the market’s function for some investors? Provide a specific example. Why is this an accurate description of the market’s function for other investors? Provide a specific example.

PLEASE only answer this question if you know the correct answer

Answer 1

DERIVATIVE MARKET:

Derivatives are securities whose prices are derived from an underlying asset which may be a share , commodity or foreign exchange.

The most common from of derivatives traded in the market are:

• Futures
• Options

Futures contracts are agreement between two parties to buy or sell and asset at a specified price on a future date. Suppose share X is currently selling at $50 per share. If a trader expects that price will go up he can buy futures with a specified settlement day at a specified price(say $52 per share). If on the day of settlement price is higher than $52 , the trader gains and if the price is lower than $52 , he looses. If one sells the future(expecting price will go down) , the reverse will happen. He will gain if the price on the settlement is lower than $52 and will loose, if the price is higher than $52.

Futures contract are high risk and high gain strategy.

Option contract gives the buyer of option a right to buy(in case of Call option) or sell(in case of Put option) an underlying asset at a specified future that (expiry date) at a specified price(strike price). There is no obligation on the part of buyer to buy or sell. He has only the right, and for this right, he needs to pay an amount(Option premium) to the seller of the option.

The seller of the option assumes the obligation to buy or sell at strike price. For taking up this obligation, he is compensated by the option premium.

In case of American option, the buyer has the right to settle the contract on any future day till expiry.

Suppose share X is currently selling at $50 per share. If a trader expects that price will go up he can buy Call option with a specified settlement day at a specified price(say strike price of $50 per share).This will give him the right to buy the share at $50 without any obligation to buy. Only , if the price on settlement day, share price is higher than $50, he will chose to exercise the option and make profit( by selling the share at higher price in the market). Otherwise, he just looses the option premium.

If a trader expects that price will go down, he can buy Put option with a specified settlement day at a specified price(say strike price of $50 per share).This will give him the right to SELL the share at $50 without any obligation to buy. Only , if the price on settlement day, share is lower than $50, he will chose to exercise the option and make profit(by buying from market at lower price and give delivery). Otherwise, he just looses the option premium.

The seller of options has obligation to sell (in case ofCall option) and buy (in case of Put option) at the strike price.

The buyer of option has limited loss(option premium) with scope of unlimited gain.

The seller of option has limited gain(option premium) with risk of unlimited loss.

• Tools for risk management

Derivatives are used by some investors for management of risk. In this case it is not speculation or gambling.

For example , if you are invested in shares and you expect that market will go down. You can protect the value of your investment by selling in futures market or buying the Put options in the option market. If the market falls, value of your investment will go down but it will be compensated by gain in futures/options

Similarly, if a company needs to pay in foreign exchange in future, it can manage the foreign exchange fluctuation risk by buying in futures or options to lock the foreign exchange rate.

• Speculation

For other investors the derivative market is speculation like short term traders in share market. It provides them the opportunity to take higher risk with limited amount of investment. This increases the risk of traders.

In futuresa trader can buyor sell a large amount by paying a small percentage of total value. Similarly, in the option market, the option premium is very small.

Like in share market, the derivative market speculators serve the purpose of market creation and improve price discovery and market efficiency