What is a derivatives market?

A derivatives market is the financial market for derivatives. What does that mean exactly? First you have to understand derivatives. A derivative exists to reduce risk. The value of a derivative changes in response to changes in underlying variables such as: stocks, bonds, interest rates, commodities, and exchange rates.

A derivatives market is your bet on the value of the stock, bond, or currency to increase or decrease by a certain amount over a fixed period of time. A derivatives market can be divided into two parts: future markets and over-the-counter markets.

Future Markets
In a future market, the owner is responsible for buying and selling the asset. When you buy a future contract, it is called "long". This means that another party has to go "short". When a new contract is introduced, the total position in the contract is zero. This means that the sum of all "long" investors must be equal to the sum of all the "short" investors. It is basically a transfer of risk from one party to another.

Over-the-counter Markets
Over-the-counter Markets are better known as the OTC market. The OTC market consists of investment banks with traders who make markets in derivatives. You will find swaps, forward rate agreements, forward contracts, credit derivatives, and other products in this market.

So with all that information, you may still be asking yourself what a derivatives market is. Generally speaking, it is a contractual agreement that offers a means for individuals or businesses to rearrange the risks they may face in the future.

Derivatives provide for certain rights or obligations between two parties. A marriage proposal has some common elements of a derivative. With a marriage, a couple comes together with certain vows of responsibility and obligation. They are agreeing now to make a long-term deal.

Both investors will put up a good faith deposit or "margin". This will represent a small fraction of the value of the contract, it is meant to serve as a protection against default.

History has shown that the value of a derivatives market depends upon those who actually need it, not those who are seeking a profit from the market. This leads many to adopt in options. They are a little different from most parts of a derivatives market because they give one part a right to initiate a transaction at some future date based on established terms. Many investors compare options to insurance products. It is like a homeowner's policy where you are required to pay a premium before you can receive anything. Generally speaking, once an investor has paid the "premium" they are under no obligation to come up with the necessary money to cover the specified contract price if they wish to obtain full ownership. (This mostly relates to real estate.)

Swaps are another part of a derivatives market. Two parties agree to exchange one or more payments during an established time period based on conditions determined at the outset. Credit and currency markets often have swap contracts.

Being forewarned is the best thing you can do if you follow a derivatives market. Worst case scenarios can happen all the time such as brokerage firms and banks shutting their doors. The market plunging and investors who were not prepared will lose everything. If interest rates increase, taxes will rise, and of course the economy will grind to a temporary halt. Anyone who is left in the dark will struggle to break even or gain even a small profit. Many people will be left waiting for the market to pick back up to get them out of their slump. Understanding your derivatives is the best tool you have. After all, they exist to help reduce your risk!