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Difference Between Cash Market and Derivative Market

Difference Between Cash Market and Derivative Market

Financial markets are those in which two sides (buyers and sellers) exchange financial instruments such as securities, currencies, commodities, etc. Different types of financial markets may be distinguished based on factors such as nature, claim, time, structure, etc. Financial markets may be divided into two categories; derivative markets and cash markets, depending on the kinds of products that are exchanged there. While the derivative market trades contracts, the cash market trades assets. In this article let’s understand What is Cash Markets and Derivatives Markets.

What is the Cash market?

Cash markets are marketplaces where assets are traded, and transactions occur in real-time. Financial commodities are purchased, sold, and transferred ownership as potential purchasers pay for them. Because transactions are completed on the spot, cash markets are also known as spot markets. Transactions are finalised in real time, often within two to three business days. Investors benefit from liquidity because cash market transactions are completed rapidly. Liquidity gives you more flexibility and the capacity to take advantage of short-term opportunities. For instance, the Stock Exchange, over-the-counter trades, and so forth.

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Table of Content

  1. What is the Cash market?
  2. What is a Derivative Market?
  3. Difference Between Cash Market and Derivative Market
  4. Participants of the Derivatives Market 
  5. Advantages of the Derivatives Market 
  6. Disadvantages of the Derivatives Market
  7. Points to be Aware of While Using Derivatives

What is a Derivative Market?

Derivative Markets are exchanges where derivatives such as futures and options are exchanged. Trading derivatives such as options contracts and futures exchanges aid in risk management, speculation, and profit maximisation. Investors tend to invest more because the return on investing in derivative markets is greater than the risk. There are two types of derivative markets: exchange-traded derivatives and over-the-counter (OTC).

Difference Between Cash Market and Derivative Market

Here is the difference between the cash market vs. Derivative market:

AspectCash MarketDerivative Market
MeaningImmediate asset tradingFutures and options trading are examples of derivative instruments.
OwnershipOwnership is transferred upon delivery.Never become a property owner.
Lot SizesAllows for the trade of single unitsIt is not possible to trade single units.
DividendsDividend-paying investorsDividends are not payable to investors.
Trading ModeA trading and Demat account are required.A futures trading account is required.
Nature of AssetsTransactions in tangible assetsTransactions in both tangible and intangible assets
Lot SizesInvestors in cash markets can purchase or sell in any number, even single units.The lot sizes in derivatives markets are set, and single units are not accessible.
Duration

Lifetime ownership is provided by transactions.

 

Transactions have an expiration date.
Nature of assetsThe cash market only deals in physical assets.Markets for derivatives may be used to exchange both tangible and intangible assets.
Trading modeInvestors in cash markets require both a trading and a Demat account.Investors in the derivatives market just require a future trading account.
DividendsInvestors in cash markets have the right to dividends.Investors in derivative markets have no rights to payouts.
OwnershipInvestors hold ownership of the asset (share) that they acquired.Investors do not own the asset that they have acquired.

Participants of the Derivatives Market 

Derivative markets consist of four major participants. Given below are a few details of the same:

  1. Hedgers

    Investors who participate in the derivatives market to remove the risk of future fluctuations in asset values are known as hedgers. Instead of making money, the main goal is to safeguard the exposure already had in the market or to lower the risk.

  2. Speculators

    Traders who take calculated risks to make money are known as speculators. They forecast the values of an asset or derivative based on the future movement of the underlying asset.

  3. Margin traders

    The nominal proportion of the investment's value that the investor must deposit as a margin to offset the investment's risk is known as the margin. Traders use the money on margin to buy more equities.

  4. Arbitrageurs

    The practice of profiting from an asset's price discrepancy between two marketplaces is known as arbitrage. To make money, arbitrageurs buy an asset in one market at a cheaper price and sell it in another market at a higher one.

Advantages of the Derivatives Market 

Despite being riskier than primary markets, derivative markets provide several benefits. The next section discusses a few of them:

  1. Reduced Capital Investment

    Derivatives are a great way for those with less cash to trade in the stock market. Compared to main investment vehicles such as shares and mutual funds, investors can obtain good returns with a smaller initial capital input.

  2. Lower Investment Costs

    Investing in fundamental assets such as shares and debentures is more expensive than investing in derivative markets. The less capital outlay further lowers the investors' cost of investing.

  3. An Efficient Method for Managing Risks

    One useful method for lowering investing risk is the derivatives market. In addition to hedging their risks, players in the derivatives market might profit from arbitrage. As a result, traders in derivatives have higher potential profits.

    Disadvantages of the Derivatives Market

    Let's talk about the limitations of derivatives markets after reviewing their benefits. 

    1. Risks

      The risk associated with the derivatives market is by far its biggest drawback. Comparatively speaking, these markets are far riskier than primary markets. Participants may suffer significant losses if the risk is not well controlled.

    2. Complexity 

      Because of the complexity of the contracts in derivatives markets, involvement requires an in-depth understanding of the market. If a beginner does not comprehend how these markets work and the contracts they enter, they might lose more money than they make.

    3. Speculation 

      The secret to maximising gains in these markets is speculation. Due to the volatility and increased risk associated with these markets, investors may experience larger losses or lose all their funds.

    Points to be Aware of While Using Derivatives

    When utilising derivatives, investors need to be mindful of a number of variables. These elements are covered in the section that follows:

    • Market research is the primary criterion for entering derivative markets.
    • Investors must understand the risks associated with derivative investments.
    • Margin money is required before trading in derivative markets.
    • Futures trading accounts must be opened by a broker that allows derivative trading.
    • Asset class and lot sizes should be chosen based on margin capabilities and risk return parameters.
    • Positions can be held until the last day of the contract for maximum returns.

    Conclusion
    Many traders with a high-risk tolerance find derivatives an appealing investment choice. It enables them to manage their risks and benefit from arbitrage. However, it is a high-risk game, and investors who do not take measured risks or over-expose themselves risk falling and losing all of their wealth. As a result, before entering these marketplaces, it is best to be well-versed with them. However, using a reliable stock market app is important to understand the market insights. The above article lets you learn about the difference between cash and derivative markets.

    Cash Market Vs Derivative Market FAQs

    No. To trade derivatives, investors will need to create a futures trading account. They must guarantee that their broker enables derivative trading; if not, investors must seek for a new broker that does.

    Yes. Commodities are traded in derivative markets, and their prices are determined by various underlying variables such as global commerce, demand-supply pressures, etc.

    No, investing in derivative markets is less expensive than main investment options, and less capital expenditure lowers the investment cost even more.

    The financial market encompasses various assets like stocks, bonds, commodities, etc., facilitating funds exchange. Derivative market, a subset, trades contracts deriving value from underlying assets, used for risk management and speculation.

    No, a currency itself is not a derivative. Currencies are primary financial instruments representing money in the form of coins or banknotes issued by governments and central banks, used as a medium of exchange for goods and services.