Reasons for the use of derivatives

Reasons for the use of derivatives

What are the reasons for the use of derivatives?

Deriving its value from assets or a group of assets, derivatives are a kind of financial instruments of security. It is a contract between two parties or more and its price is calculated by monitoring the fluctuations occurring in the underlying assets such as commodities, currencies, market indexes, interest rates, bonds, stock price etc.

There are two categories of derivatives namely over-the-counter OTC Derivative and exchange-traded derivatives.

OTC derivatives are designed and customized by the investors or the trading parties involved.

Exchange-traded derivatives, on the other hand, are openly traded in the stock exchange set up.

There are four types of financial derivatives: Forwards, futures, options, swaps

 

Forward Contract:

The simplest and oldest form of derivates available; forward contracts specify that something will be sold to someone at a particular predetermined price on a particular date. These contracts are made between counterparties so the exchange isn’t a liaison or intermediary for the transactions. This, in turn, increases the counterparty credit risk.

Futures Contract:

Futures Contract as a type of derivative is quite similar to a Forward contract; meaning these contracts also mandate that a particular commodity will be sold to a particular person on a given date for a given price. However, the difference lies in the fact that they are listed on the exchange. This means that there is a valid intermediary or liaison here. This is why these contracts are very standard in their format and cannot be modified. These contracts for futures exchange come in a predefined format, size and expiration dates.

Options:

This derivative type is very quite different from the first two options.  In case of futures and forward contracts, there is a contract that both partied need to abide by the terms of the contract and have to buy or sell at the date defined in the same. However, in the case of buying an options contract, one of the parties is bound by the contract, whereas the other party has an option whether or not to meet the terms on the expiry date.

The party that has an option has to pay a premium to avail this privilege. There is a call option and a put option. The call option renders you the right, but you are not under any obligation to buy a commodity on the future date at a given price. On the other hand, the put option renders you the right but doesn’t obligate you to sell something at a given price at the expiry date of the contract. These calls and put options make things flexible for investors.

Swaps:

These are said to be the most complex forms of contracts in the derivatives market, there is an exchange of cash flows here. For example, one party may choose to switch one cash flow which is uncertain with another. One of the commonest forms of swapping is exchanging a fixed interest rate with a floating interest rate. The parties involved may choose to swap underlying currency as well besides interest rates. Swaps make it possible for companies to avoid foreign exchange risks besides other risks. Swaps aren’t traded via the exchange; they are usually carried out privately amongst both the parties. These contracts are usually brokered by investment bankers.

 

Why are derivatives used?

Conventionally, derivatives are used for hedging market or other systematic risks like market movements, interest rates, inflation, and currency fluctuations and so on. These risks are inevitable and derivatives prove to be a cost-effective way to reduce and manage them from time to time.

Uses of derivatives in Portfolio Market

With several different types of underlying securities such as commodities, market indices, equity, fixed income etc; the investment in derivatives exposes the investor to a diverse range of asset classes. There are several ways derivatives can be used in portfolio management.

There are several situations where derivatives can be used in the Portfolio Market.

In volatile markets:

When the markets are fluctuating, derivatives can be used to hedge a position, which in turn helps in protection against the risk of an adverse move in the market.

If interest rates are expected to change:

When interest rates are expected to change, the use of swap options safeguard your investment against the risk of an ever-changing dynamic of the market and dealing with exchange rates.

When buying and selling stocks:

Derivatives are traded while buying and selling of stocks for optimum risk management and ensuring safe returns. This is done in an endeavor to reduce risk without reducing the opportunity

Arbitrage:

Derivatives are used for arbitrage where you want to strike a chance to buy low and sell high. Such opportunities may present themselves in various derivatives markets and an investor could definitely cash on it.

Let’s understand how it all works with the help of an example:

Suppose an investor was to buy 1000 shares of Amazon.in on the 5th of May 2016 for the price of $65 per share. They hold their shares for over 2 years and are now of the view that Amazon may not be able to make the projected earnings per share and cover their revenue expectations.

The stock price for Amazon opens at $243.93 on May 15, 2018. Now the investor wishes to lock at least $165($65+$165=$230) in terms of profit per share, on their investment. Here they would hedge the price to protect the deal from price fluctuations in the company. For this, they buy 10 put options on Amazon.in, that have a strike price of $230 and the date of expiry is 7th September 2018.

Now because of the put option contract, the investor has the right to sell his shares for the price of $230 per share. Here, because one stock option contract uplifts 100 shares of the underlying stock in question, the investor could, if they wanted to, sell 1000 shares with the help of 10 put options.

Finally, Amazon.in is to report its earnings on the 5th of September; if it misses the expectations; with stock prices being below $230; the investor can fall back on the locked sell price of $230 because of their put options trading. They could now sell 1000 shares while gaining a decent profit of $165 per share in the process. However due to some reasons, if the stock rises beyond $230, the investor need not exercise the put option and allow it to expire.

Derivatives act as the catalyst to secure trade, whether in the stock market or when privately trading between two parties.  Derivatives help in the allocation of assets and ensuring handsome returns. Working on the principle of leverage, investors can reveal themselves to a large part of the market with the help of calculated, minimal risks with the intelligent use of derivatives.