Why do we need derivatives? 

Derivatives play a crucial role in the economy by serving three essential functions:

1. Price discovery: Derivatives help determine the fair price of an underlying asset, providing market participants with valuable information about future price expectations.

2. Risk management: Derivatives enable individuals and organizations to hedge against potential losses or gains, managing risk and providing a sense of security in uncertain markets.

3. Speculative activity: Derivatives allow investors to take positions on future market movements, providing liquidity and contributing to market efficiency.

These functions are essential for a well-functioning economy, as they facilitate informed decision-making, risk management, and market efficiency.

PRICE DISCOVERY 

Derivatives play a crucial role in determining the prices of commodities and financial assets, making them a vital component of a well-functioning economy. Market participants anticipate price movements, and futures market prices reflect their expectations of future demand and supply. This, in turn, influences the spot market price.

For instance, a sugar manufacturer can use futures market prices to predict the price of sugar two months in advance, enabling them to plan production accordingly. Similarly, jewelers in Mumbai and Delhi can reference the gold futures contract price on the NSE to set spot market prices in their local markets, ensuring a profitable price, despite potential regional price variations.

The above examples illustrate this:

1. The sugar manufacturer can use futures market prices to anticipate future prices and adjust production plans accordingly.

2. The jewelers in Mumbai and Delhi can use the gold futures contract price on the NSE as a benchmark to set spot market prices in their local markets, ensuring a profitable price.

Derivatives facilitate price discovery by:

• Reflecting market expectations of future prices

• Providing a benchmark for spot market prices

• Enabling informed decision-making for producers, consumers, and traders

Managing Risk with Derivatives

As an individual or organization, you're exposed to unforeseen losses due to market uncertainties. Derivatives can be a valuable tool to mitigate risks associated with price fluctuations.

Let's consider an example. Suppose you hold Reliance shares currently trading at Rs. 2000, and you anticipate a price drop to Rs. 1800. You can sell Reliance futures at Rs. 2300, locking in your profit. If the price indeed falls to Rs. 1800, you would have avoided a loss of Rs. 200 per share. This strategy is called hedging, which involves making a new investment to offset potential losses in an existing one.

Another example: if Reliance shares are trading at Rs. 1800, you can buy Reliance options with a strike price of Rs. 1800. This gives you the right to purchase shares at Rs. 1800. If the share price remains the same or falls below Rs. 1800, you won't exercise the option, limiting your loss to the premium paid. However, if the price rises to Rs. 2000 or higher, you can exercise the option, of buying shares at Rs. 1800, and selling them at the higher market price, earning a profit. In this case, the potential profit is unlimited, and the maximum loss is the premium paid.

In the example, if you paid a premium of Rs. 20 and the lot size is 500, your potential profit would be Rs. 3,40,000 (Rs. 700*500 = Rs. 3,50,000 minus Rs. 10,000) if the price rises to Rs. 2500.

Derivatives empower informed investors to capitalize on price movements and manage risk effectively.

Speculation

Speculators play a significant role in the financial markets, influencing price movements through their trading activities. These price fluctuations are often driven by market sentiments, rather than the underlying fundamentals of the stock. Speculators seek out stocks that are overvalued or undervalued, aiming to profit from potential price corrections.

For instance, if a speculator believes a stock is overpriced and due for a decline, they may sell the stock. This can trigger a trend, as other investors follow suit, leading to a large volume of sales that brings the price back in line with its true value. By doing so, speculators contribute to market liquidity and help maintain equilibrium in the prices of shares.

In essence, speculators act as market catalysts, facilitating price discovery and ensuring that stock prices reflect market sentiments, even if they deviate from fundamental values.