In Economics, a market is a system where buyers and sellers interact to trade commodities and set prices. This market can be further narrowed down as a financial market which is a platform for people and firms to exchange financial instruments and securities. There are various specific functions of financial markets including finance through stocks and management of financial risks. These functions are carried out in the equity and derivative markets respectively.
An equity market is a network of financial transactions where stocks are traded and ownership of securities is allotted. It is popularly known as the stock market or stock exchange. The equity market is one of the primary methods of capital generation for firms and companies. It revolves around trading shares of ownership of a company in a public market. The movement of prices in a stock market is measured by the price indices.
The market can be further divided into primary and secondary markets. The trade in stock exchanges is done both manually and digitally. The equity market is also considered as an indicator of economic growth of the country. The dynamics of equity markets are strictly supervised by the central banks to control its volatile behavior. Over time the participants of the equity markets have shifted from individuals to institutions such as mutual funds, pension funds, insurance companies etc.
Derivative Markets are markets for trade of financial instruments whose characteristics are derived from underlying securities, assets or indices. The function of derivative markets is ‘hedging’ and management of risk along with speculation. The value of a derivative contract moves into the opposite direction of the underlying asset and cancels it out thereby reducing the risk.
By this principle, insurance companies mitigate risk and provide compensation in situations of crisis. The derivatives also offer to increase profit of companies if the value of the underlying asset is correctly speculated. But this practice entails risk which is often kept undisclosed. Thus it can be correctly concluded that derivative markets are platforms for both acquisition and mitigation of risk.
The derivative contracts can be divided into two subdivisions:
Over the counter derivatives: These contracts are directly negotiated between two parties without any intermediate exchange. Swaps, exotic options are traded through this approach.
Exchange traded derivatives: These contracts are traded through special derivatives exchange.
The most common derivative contract types are forwards, futures, options and warrants.