10.4 Users Of Derivatives

The Users of Derivatives

Understanding the different participants in the derivatives market is essential for grasping how these financial instruments function. Users of derivatives can be broadly categorized into four groups:

1. Individual Investors
2. Institutional Investors
3. Businesses and Corporations
4. Derivative Dealers

Individual Investors

Individual investors typically use derivatives to speculate on the future price movements of an underlying asset. For example, they might purchase options to bet on stock price trends or use futures contracts to speculate on commodities. While individual investors can gain significant leverage through derivatives, it’s important to note that these are high-risk strategies primarily suited for those with substantial market knowledge.

Institutional Investors

Institutional investors, such as pension funds, mutual funds, and insurance companies, often use derivatives for hedging to manage risk in their investment portfolios. For example, a mutual fund might use options to protect against potential losses in its stock holdings. These institutions have experienced financial professionals who assess and manage risks using a variety of derivative instruments.

Businesses and Corporations

Companies leverage derivatives primarily to hedge against fluctuations in commodity prices, interest rates, and foreign exchange rates. A company import/export business, for instance, might use currency futures to protect against currency exchange rate volatility when conducting international transactions. This application of derivatives helps companies stabilize their costs and projections.

Derivative Dealers

Derivative dealers act as intermediaries in the market. They facilitate transactions by buying and selling derivatives to meet the demands of their clients, which includes the other three groups mentioned. Dealers don’t typically retain large positions themselves; instead, they earn their profits through the volume of transactions. These functions are crucial to the liquidity and efficiency of the derivatives market.

Here’s a flowchart that simplifies the relationships among different users of derivatives:

    graph TD
	  A[Derivative Market] --> B[Individual Investors]
	  A --> C[Institutional Investors]
	  A --> D[Businesses & Corporations]
	  A --> E[Derivative Dealers]
	  E --> B
	  E --> C
	  E --> D

Key Takeaways

• Individual Investors: Primarily use derivatives for speculative purposes.
• Institutional Investors: Utilize derivatives for hedging to manage the risks of large, diversified portfolios.
• Businesses and Corporations: Use derivatives to hedge and manage risks associated with operational and financial exposures.
• Derivative Dealers: Serve as market intermediaries, providing liquidity and balance without holding large positions.

Glossary and Definitions

• Derivative: A financial instrument whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies.
• Speculation: The act of trading with the expectation of significant returns by risking on the future price movements of an asset.
• Hedging: A risk management strategy used to offset potential losses in one investment by making another to reduce the risk.
• Options: Contracts granting the right, but not the obligation, to buy or sell an asset at a set price before a specified date.
• Futures: Contracts obligating the purchase or sale of an asset at a predetermined price at a future date.

Frequently Asked Questions (FAQs)

What are the primary purposes of using derivatives?

Derivatives are primarily used for hedging risks or speculating on price movements of underlying assets.

How do derivative dealers operate?

Derivative dealers act as intermediaries between buyers and sellers, providing liquidity to enhance market efficiency. They make profits from transaction fees rather than holding large positions themselves.

Why is hedging important for businesses?

Hedging allows businesses to stabilize costs and reduce uncertainties related to fluctuating prices, interest rates, and currency exchange rates.

What is the difference between speculation and hedging?

Speculation involves taking on risk for potential profit from price changes, whereas hedging involves minimizing risk to manage potential losses.

Can individual investors use derivatives successfully?

While individual investors can benefit from derivatives, these instruments carry high risks and are best suited for those with substantial market knowledge.

In this section

• 10.4.1 Individual Investors
  Comprehensive guide on individual investors and their involvement with exchange-traded derivatives
• 10.4.2 Institutional Investors
  Detailed guide on institutional investors and their use of derivatives including strategies like hedging, market entry and exit, arbitrage, and yield enhancement.
• 10.4.3 Corporations And Businesses
  Explore how corporations and businesses utilize derivatives for hedging risks related to interest rates, currencies, and commodities.
• 10.4.4 Derivative Dealers
  Learn about the role of derivative dealers in both exchange-traded and OTC markets in Canada, including the functions they serve and the key types of institutions involved.