Why Do We Need the Derivatives Market?

The market of derivative financial instruments plays an important role in the global economy. Futures exchanges where derivatives are traded function as the centers of pricing for many assets and also as mechanisms that make it possible to re-distribute various financial risks among the participants in this market. The terms derivative financial instruments and derivatives are synonyms. The instruments are referred to as derivative because their value depends on the value of other assets that form their basis, which are referred to as underlying assets. Distinctive features of derivatives are a high level of leverage and fulfilling obligations in the future. Underlying assets may be comprised of both real assets that are subject to civil law, which may be transferred in the market and may be owned by a party to a transaction (for example, securities, foreign currency, commodity assets, etc.), and virtual assets, not transferable owing to their nature, which may not be owned by a party to a transaction (for example, price indices, interest rates, exchange rates, other indicators characterizing certain events or phenomena, or opinions of the parties). The use of derivative financial instruments provides economic entities with greater opportunities to minimize risks, improve the conditions for attracting and placing funds (since it provides investors and issuers with a wide range of previously unavailable methods of risk management and finance management), reduce expenses when creating portfolios with specific parameters, and enhance the liquidity and price effectiveness of the markets. Owing to these features, forward contracts account for a large portion of professional asset managers investment portfolios as well as those of institutional and individual investors. Various economic entities, from financial organizations to production and agricultural enterprises and trade firms, use derivatives to restrict and eliminate their financial risks. The variety of opportunities afforded investors in the derivatives market is accompanied by a speculative component inherent to the derivatives market that results from a high level of leverage (and, consequently, a much higher level of potential return), where the same financial result may be obtained with much lower initial costs compared to transactions in spot markets. Along with highly favorable opportunities for speculative trading aimed at deriving profit by performing high risk operations, the derivatives market is also of interest to non-riskseeking investors who are in a position to use derivatives to perform low risk operations with a small rate of return based on identifying temporary price disproportions in financial markets (arbitrage operations). In the exchange-based derivatives market, futures and options are traded. As financial instruments, they enable the performance of speculative operations on the basis of the same knowledge, skills, abilities, and information that are used in the markets of underlying assets (securities, foreign currencies, commodity assets, etc.). At the same time, the list of opportunities provided by these instruments and the strategies for their use is much wider. Using futures and options in the MICEX Derivatives Market provides market participants and investors with the following opportunities:

high-yield speculative operations with various assets, including currency futures, with considerably lower costs and higher reliability compared with the FOREX market; arbitrage operations in underlying assets markets and with various forward contracts; effective hedging of market risks by stock portfolios and optimizing return on portfolios with the help of stock derivatives and MICEXIndex derivatives; limiting the interest rate risk for portfolios of fixed return instruments on various segments of the yield curve; lowering the currency risk for investment portfolios and export and import operations; managing liquidity by generating synthetic swap trades and REPO trades with the help of currency futures, stock futures, and opposite trades in the markets of underlying assets; lowering the volatility of revenues and expenses, supporting long-term planning and financing operating processes.

The wide range of opportunities provided by the organized derivatives market leads to several different categories of participants in the MICEX Derivatives Market:

commercial banks: both major domestic credit organizations that are among the most active in the money markets and subsidiaries of foreign banking organizations; financial companies: investment banks and broker companies, including leading Internet brokers in Russias stock market; investment portfolio trustees and collective investment institutions; large production and trade organizations, participants in foreign economic activities; individual investors. In terms of the goals pursued, the participants in the MICEX Derivatives Market may be divided into the following categories:

Hedgers are participants who open their positions in the MICEX Derivative Market for the purpose of hedging, that is, limiting their risks in the market of the underlying asset. When operating in the derivatives market, these participants seek to protect themselves against unfavorable price changes in the underlying asset markets. The MICEX Derivatives Market provides them with the opportunities to insure their risks in the equity market, the fixed return instruments market, and in the markets of currency and commodity assets. On the other hand, the participants hedging their risks are prepared to suffer some losses in the derivatives market if the price movement in the underlying asset market is favorable to them. Hedgers form the basis for the profit derived by speculators.

Arbitrageurs are market participants seeking to derive profit from price disproportions and price differences in various markets. The participants belonging to this category do not aim to derive profit by assuming heightened risks related to strategies based on price changes, volatility, and other market indicators; they are interested in the overall financial result in all markets simultaneously. The MICEX Derivatives Market provides them with the maximum arbitrage opportunities owing to the ability to trade in various forward contracts and the concentration of trading turnover in underlying assets in the MICEX spot markets.

Exchange speculators are the basis of forming liquidity in any market. These are the market participants who deliberately assume the risks related to changes in prices and other market parameters for the purpose of deriving profit. The MICEX Derivatives Market provides wide opportunities for speculative operations. To perform operations with forward contracts, the market participants must provide a security deposit (deposit margin) for supporting an open position, the amount of which usually varies from 3% to 20% of the value of the underlying asset for various instruments, which considerably reduces active market players costs and also enhances leverage.