Derivatives are financial contracts that derive their value from an underlying assets like stocks, stock indices, commodities or currencies. All these underlying assets change in value from time to time. So derivatives are basically introduced to transfer these risks from risk averse investor to the risk appetite investor. Two specific derivatives that form a major role in any stock exchange are
Three kinds of traders play a major role in derivatives segment. They are Hedgers, Speculators and Arbitrageurs.
Hedgers are those who hedge the risk of falling or increasing of price of the share that they are willing to sell or purchase in the cash market at some point in the future by taking opposite position in the derivatives segment.
Speculators are those who expect the market to fall when others expect them to raise in future. So speculator enters into agreement with the one who wants to protect his shares that he wants to sell at a future time from fall in prices. So speculator agrees to buy the shares at a pre determined price from the hedger. But if the price moves up, obviously the hedger will not sell it to the speculator, since he can make more money by selling it directly in the market. So Speculator will be given a compensation of some amount instead for entering into this contract.
Arbitrageurs are those who make use of the difference in prices prevailing between the cash market and the derivatives segment and thus make a riskless profit. For example if a share is traded at Rs 100 in cash segment and Rs 105 in futures segment, he will buy the same at Rs 100 in cash segment and sell the same share at Rs 105 in the futures market. On the Contract expiry day, the prices of the share in cash segment and derivatives segment will converge when he can take the pre-determined profit without any risk.