Lets see the roles of 3 major market participants namely Hedgers, Speculators and Arbitrageurs in the derivatives market.
Derivative products are used to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices. This is done by corporations, investing institutions, banks and governments alike. A classic example is the farmer who sells futures contracts to lock into a price for delivering a crop on a future date. The buyer could be a food processing company, which wishes to fix a price for taking delivery of the crop in the future.
Another case is that of a company due to receive payment in a foreign currency on a future date. It enters into a forward transaction with a bank agreeing to sell the foreign currency and receive a pre-determined quantity of domestic currency.
Derivatives are well suited to trading on key market variables such as interest rates, stock market indices and currency exchange rates and on prices of commodities and financial assets. It is much less expensive to create a speculative position using derivatives than by actually trading the underlying commodity or asset. As a result, the potential returns are much greater.
A classic application is the trader who believes that increasing demand or scarce production is likely to boost the price of the commodity.
He has two options with him - first option is to buy and store the physical commodity whereas other option is to go long on futures contract.
Trader chooses the second option to go long futures contract on the underlying asset. If commodity price increases, the value of the contract will also rise and he can reverse back position to book his profit.
An arbitrage is a deal that produces risk free profits by exploiting a mispricing in the market. A simple arbitrage occurs when a trader purchases an asset cheaply in one exchange and simultaneously arranges to sell it at another exchange at a higher price. Such opportunities are unlikely to persist
for very long, since arbitrageurs would rush in to buy the asset in the cheap location and simultaneously sell at the expensive location, thus reducing the price gap.
These 3 major players in the derivatives market play this way - hedgers hedge their risk, traders take the risk which hedgers plan to offload from their exposure and arbitrageurs establish an efficient link between different markets.