Hello everyone!

In this video we will be discussing various participants in the derivatives

market.

So, there are three main types of participants: hedgers, speculators, and
arbitrageurs.

Who are Hedgers?

Hedgers are individuals or companies who use derivative contracts to protect

themselves from future price changes.

Just like we discussed in the 1st video, imagine an Indian spices and masala
manufacturing company like MTR Masala that makes a variety of powders used
in Indian kitchens. We all know that turmeric is one of the common ingredients
that we find in all the Indian masala powders. So, MTR needs to buy a lot of
turmeric from the market. MTR is worried that the price of turmeric might go
up in the future due to factors like bad weather or increased demand. If the price
of turmeric increases, the company’s costs will rise, and their profit margins
could shrink.

To protect themselves from rising turmeric prices, MTR decides to hedge by

entering into a futures contract. They agree to buy a large amount of turmeric
from a trader at today’s price, but for delivery after six months. This way, even
if the price of turmeric shoots up in the future, MTR will still pay the lower
price they locked in using the futures contract. By doing this, the company
avoids the risk of paying higher prices for turmeric and ensures stable costs for
their masala powder production.

Similarly, a farmer growing turmeric might worry that by the time his turmeric
crop is ready for harvest, the price could fall, meaning he won’t make enough
profit. To protect against this, the farmer also enters into a forward contract with
the trader to sell his turmeric at today’s price, even if prices drop later. This way,
the farmer is guaranteed a stable income, regardless of future price fluctuations.

In both cases, MTR and the farmer are using derivative contracts to lock in
prices and avoid risk from unpredictable price changes in the turmeric market.
This process of using derivatives to manage risk is called hedging.

Okay, now who are speculators?

In the case of speculators, they are neither producing turmeric like the farmer
nor using it to make masala powders like MTR. Speculators are simply market
participants who try to make a profit by predicting price movements.

Imagine a speculator who believes that the price of turmeric will increase in the
future due to reasons like bad weather or rising demand. This person doesn’t
need turmeric for any business or production purposes—they are simply betting
on price changes. So, the speculator enters into a futures contract, agreeing to
buy 1,000 kgs of turmeric from another party at a fixed price of Rs. 100 per kg,
three months from now.

If the price of turmeric rises to Rs. 120 per kg after three months, as the
speculator predicted, he can still buy it at the agreed price of Rs. 100 per kg,
thanks to the forward contract. Then, he can sell it in the market for Rs. 120 per
kg. In this case, the speculator would make a profit of Rs. 20 per kg. Since the
contract is for 1,000 kgs, the total profit would be Rs. 20,000.

However, if the price of turmeric falls to Rs. 70 per kg after three months, the
speculator will still have to buy it at Rs. 100 per kg. If they sell it in the market
at Rs. 70 per kg, they would incur a loss of Rs. 30 per kg. With 1,000 kgs, the
total loss would be Rs. 30,000. This is why speculating is risky—it can lead to
big profits, but also big losses. It’s like a double-edged sword.
Now, when it comes to settling the contract, many speculators choose cash
settlement instead of physical settlement to avoid extra costs. In the turmeric
example, if the contract is physically settled, the speculator would have to
actually take delivery of 1,000 kgs of turmeric, which involves storage,
transportation, and other logistics costs. To avoid these extra expenses,
speculators often opt for cash settlement, where they don’t take delivery of the
actual turmeric. Instead, the difference between the contract price and the
market price is settled in cash.

For example, if the price of turmeric goes up to Rs. 120 per kg, the speculator
can simply receive the profit of Rs. 20,000, without needing to handle the
physical turmeric. Similarly, if the price drops to Rs. 70 per kg, the speculator
would pay the loss of Rs. 30,000 in cash, instead of buying and selling turmeric
in the market.

I hope this is clear.

Now, who are arbitrageurs?

An arbitrageur is someone who looks for price differences in different markets

to make a risk-free profit. Unlike hedgers and speculators, arbitrageurs are not
trying to predict future price movements. Instead, they exploit price differences
that already exist.

Imagine an arbitrageur notices that the price of turmeric in the Hosur market is
Rs. 80 per kg, but in the Bangalore market, it’s selling for Rs. 120 per kg at the
same time. The arbitrageur sees an opportunity to make a risk-free profit by
taking advantage of this price difference.
The arbitrageur would buy 1,000 kgs of turmeric in Hosur market at Rs. 80 per
kg and immediately sell it in the Bangalore market at Rs. 120 per kg. and make
a profit of Rs. 40 per kg. For 1,000 kgs, the total profit is Rs. 40,000, without
taking on any risk.

When more arbitrageurs buy turmeric from the Hosur market and sell it in the
Bangalore market, the increased demand in the Hosur market will drive the
price up. Similarly, as the supply in the Bangalore market increases, the price
there will eventually drop. As a result, the price in both markets will gradually
move towards equilibrium, with only a minimal difference to account for
transportation costs. This shows that arbitrage opportunities don’t last for long,
as market forces quickly correct the price differences.

We will explore arbitrage opportunities in the futures market in more detail in

the upcoming videos.

In summary:

● Hedgers are like people using an umbrella to protect from rain. They protect
themselves from unfavourable price movements by transferring risk to
speculators.
● Speculators are like gamblers betting on weather. They willingly take on the
risk that hedgers want to avoid, hoping to profit from price movements. They
are risk-takers, trying to predict market directions.
● Arbitrageurs seek to make risk-free profits by purchasing umbrellas cheaply
in one market and selling them for a higher price in another. They don't care
whether it rains (or the market direction), as long as they can exploit price
differences for a profit.
That’s all for this video! See you in an another one