Derivatives have become a ready investment tool for many and also a way to increase their wealth. However, ever since this tool started gaining popularity and momentum in the market, investing has become slightly complicated.
But despite the complex structure, derivatives were initially used in the farming industry for trading agricultural produce. It helped the traders reduce risk exposure and increase their returns.
And today, this instrument has moved far beyond just the farming industry. Every other seasoned investor is looking to hedge their risks by using derivatives.
They claim that despite the complexity, this tool makes the invested wealth more safe and secure and away from the uncertainties of market fluctuations.
What are Derivatives?
As the term indicates, “Derivatives” are financial products whose value is dependent on or derived from an underlying asset. This asset could be bonds, currency, stocks, commodities, etc.
By having a derivative contract between two interested parties, they will be able to cleverly mitigate the risk exposure. Now, this exposure can be due to market volatility, uncertain events, sudden price fluctuation, or currency depreciation.
This contractual agreement is made between two parties in which one of the parties should sell or buy the underlying security whereas the other party holds an option, and no obligation to sell or buy the security.
Every derivative agreement has one thing in common, the sentiment of the binding parties. In every transaction, one party is ready to take the risk and is speculating on the trends while the other is trying to avoid the risk exposure.
The derivative, is in fact, the best investment tool for hedging against any type of market risk or even for speculating future price fluctuations.
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Types of Derivatives
As mentioned above, the value of the derivative is dependent on its underlying asset, therefore it keeps fluctuating based on the changes in the market price of bonds, commodities, currencies, interest rates, etc.
There is another way the products are classified and that is based on the terms and conditions of the contract. And these types of derivatives in India are listed below:
A futures contract, also referred to as futures in the trading market, happens to be a mutual contract between two parties who have agreed on buying and delivering a particular asset or commodity, at a set price on a predetermined date in the future.
Futures are exchange-traded standardized contracts. To put it another way, future contracts have predetermined sizes, and expiration dates. An initial margin is needed for futures contracts since settlement and collateral are handled daily.
In most scenarios, the futures contract is used by market traders when they try to speculate on price or want to manage the risk element of their portfolio. It is important that the parties diligently follow through with the completion of the contract.
The next popular type of derivative in India is known to be an options contract. The major difference between a futures and options contract is that, unlike a futures contract, there is no obligation hanging over the concerned parties to fulfill the contract terms.
In other words, the parties of the contract have the option but not the obligation to sell or purchase the underlying asset.
There are two types of options contracts- “call” and “put” options.
Call option: the buyer of the call option has complete authority of entering into the contract to acquire the underlying asset.
Put option: As for the put option, the buyer of this contract has the right but not the obligation to execute the sell order of the asset at the predetermined price.
Thus, the interested parties have in total four positions available to them that is, to take a long or short position in the call or put option.
To help with easy transactions among the traders, the options are traded both over the counter and in both the Indian exchanges (BSE and NSE).
The forward contracts are similar to futures however they are specially customized by the interested parties and are not traded in exchanges.
In this contract, two parties agree on buying and selling an underlying asset at a predetermined rate and date.
Since the contract is more flexible due to its feature of customization, the interested parties can set their date for trading the contract.
Swap contracts are considered to be quite a complex derivative tool as the contract is based on trading interest rates, cash flows, or other variable assets.
A swap contract is formed when two parties have a different outlook on the market trends. Say, for example, one party borrows money on variable interest rates while the other party on fixed rates.
Now if the variable interest rate party speculates that the market is going to go down and the fixed rate identifies an upward market trend, then an agreement is formed between the two to swap the cash flow from the interests earned.
The most common version of swap is plain vanilla, but apart from this, there are many more, such as interest rate swaps, commodity swaps, and currency swaps.
Keep note, that just like forwards, these contracts are also highly customizable and are not freely traded in exchanges. To supervise the transaction, an investment banker acts as a middleman.
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What is Risk Hedging?
Risk management techniques like hedging are widely used in the stock market. It is a sophisticated risk management technique that entails purchasing or disposing of an investment to perhaps assist in lowering the chance of loss of an existing position.
And one of the best ways to use this approach in the trading market is by opting for derivatives instead of directly investing in the stocks.
With derivations, your portfolio will be more cushioned for unforeseen events and sudden losses due to unprecedented events.
Hedging has the advantage of drastically lowering losses. Because investors may invest across a range of asset classes, liquidity is increased.
Additionally, it saves time since the long-term trader doesn’t need to keep track of or modify his portfolio in reaction to daily market volatility.
Who trades in Derivatives?
The parties involved in the derivatives market are categorized under certain segments. This segmentation is done based on their market sentiment. They are:
- Arbitrageurs: Arbitrageurs are individuals who tend to try and make profits from under-priced asset-linked derivatives.
- Hedgers: Hedging transactions are best suited for investors who are less likely to openly take the risk. Thus, they use derivatives to hedge against any market or company risk.
- Speculators: Traders who enjoy studying the market and try and gain from a shift in market prices are termed speculators. Usually, when the deal is struck by hedgers or arbitrageurs, the opposite party tends to be a speculator.
The derivatives market is run by all these three parties. They might have different risk appetites and outlooks toward market sentiment but together form the market ecosystem.
How do derivatives help with Hedging Risks?
businesses and investors use Derivatives to alter their exposure to the four main types of risk: credit risk (or default risk), commodity risk, interest rate risk, and stock market risk.
Credit Risk (or Default Risk)
The basic definition of credit risk is the risk of a company defaulting soon. Thus, if any investor holds the stock of a such company, they are exposed to credit risks.
The best way to hedge against this risk is by getting into a “credit default swap” agreement. This derivative will provide complete insurance against the credit default risk.
The terms of the agreement are that in case the company or bond defaults, then the seller of the CDS agreement will provide the defaulting amount to the buyer of CDS.
Commodity risk traders face usually or companies dealing in bulk commodities. This risk measures the interested party’s exposure to sudden changes in the price of the commodities.
So, the best way to mitigate this risk is me undertaking a “forwards” or “futures” contract.
The forwards are only transacted through the over-the-counter procedure, whereas the futures are traded in OTC and security exchanges.
Interest Rate Risk
This risk is related to fixed and fluctuating interest rates. When two parties exist who are speculating opposite trends of the market, they tend to want to get into a contract to exchange their interest rates and cash flows at the maturity period.
For such risks, the hedgers can look to get into an “interest rate swap”. With this tool, companies can safeguard themselves against any decreasing or increasing interest rates.
Stock Market Risk
Stock market risk is one of the most common risks that an investor exposes to at all times. This risk is associated with sharp price swings in the trading market. The derivative that the investors resort to is “stock equity options”.
Based on the position of the investors in the options agreement, they will have the option but not the obligation to completely execute the order at a predetermined price and date.
Investment has always been risky, thus the participants of the stock market came up with an investment tool that will allow them to mitigate the uncertainties.
And this tool is known as a derivative. It is a way to protect portfolios from uncertain events and sudden price swings.
Understanding the relationship between derivatives and risk management is one of the most important things to know. It will help a lot with future investment strategies. Hope the article helps you with clarifying the concept.
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