The concept of underlying and derivatives can be easily understood through examples. Let’s take the example of an apple. The apple itself is the underlying, possessing its own value. If we derive apple juice from it, the juice becomes the derivative. Similarly, wheat is an underlying, and when we make rotis, tortillas, or croissants from it, they become derivatives. In this context, apple juice, rotis, tortillas, and croissants are derivatives, while apple and wheat are underlyings.
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Derivatives in Finance: Futures and Options
In the world of finance and stock markets, derivatives play a significant role. Futures and options are types of derivatives commonly used in these contexts. For instance, in the stock market, you can trade contracts of underlying assets such as Nifty 50, Reliance, or HDFC. These assets become the underlying, while call options or put options for these underlyings are the derivatives. The derivatives market allows investors to trade derivatives based on various underlyings, including listed stocks within the futures and options (FNO) domain.
Also Read: Underlying asset – About, importance, types
Exploring Types of Derivatives
While there are numerous types of derivatives, we will focus on four major ones from the stock market perspective: forwards, futures, options, and swaps. In India, forwards and swaps are not as popular, and the primary focus lies on futures and options. Let’s delve into futures to understand their concept better.
Understanding Futures Contracts: Locking in Prices
Futures contracts involve agreements to mitigate future price fluctuations. Imagine you are a wheat farmer, and a businessperson is concerned about potential increases in wheat prices. To address this, both parties enter into a futures contract. For instance, you agree to sell wheat at ₹5 per kg to the businessperson in 2023. Even if the wheat prices rise to ₹8 per kg, the businessperson is obligated to purchase it from you at the agreed price of ₹6 per kg. Futures contracts allow parties to lock in prices and mitigate risks.
Explaining Options Contracts: Practical Example
To comprehend options contracts, let’s consider a practical scenario when buying a flat. Suppose you want to buy a flat worth ₹1,00,00,000, and the builder asks for a token amount of ₹1,00,000 to secure the price for a few months. During this period, you have options. First, you can exercise your right to buy the flat by paying the remaining amount. Second, you can wait and observe the market conditions, making the final decision later. Lastly, you can choose not to buy the property, forfeiting the token amount. Options provide buyers with the right but not the obligation to buy or sell an underlying asset within a specified timeframe at an agreed-upon price.
Utilizing Derivatives: Hedging and Speculation
The use of derivatives serves two primary purposes in the FNO market: hedging and speculation. Hedging involves employing derivatives to reduce risk. For instance, JSW Steel and Maruti can use futures contracts to mitigate potential losses due to price fluctuations. On the other hand, speculation refers to attempting to predict the price movement of an underlying asset. While speculation can seem enticing, it is crucial to note that a significant majority of traders do not achieve profitable results. It is advisable to use derivatives primarily for hedging rather than speculation.
Buying Insurance in the Stock Market: Options Contracts
To secure insurance in the stock market, one can purchase options contracts. There are two types of options: call options and put options. A call option grants the buyer the right (but not the obligation) to buy a specified amount of an underlying asset at a specified price (known as the strike price) within a specific time period. On the other hand, a put option grants the buyer the right (but not the obligation) to sell a specified amount of an underlying asset at the strike price within a specific time period.
Let’s take an example to understand the concept of options contracts. Suppose you own 100 shares of XYZ Company, currently trading at ₹1,000 per share. However, you are concerned that the stock price might decline in the future. To protect yourself from potential losses, you decide to purchase put options on XYZ Company with a strike price of ₹900 and an expiration date of one month.
By buying these put options, you have the right to sell your 100 shares of XYZ Company at ₹900 per share within the next month. If the stock price drops below ₹900, you can exercise your put options and sell the shares at the higher strike price, effectively limiting your losses. However, if the stock price remains above ₹900 or increases, you are not obligated to exercise the options, and you would only lose the premium paid for the options.
This insurance-like feature of options contracts makes them valuable tools for hedging against potential losses. They provide investors and traders with flexibility and protection in uncertain market conditions.
Swaps and Forwards: Customized Derivatives
While forwards and swaps are less common in India’s derivatives market, it’s still essential to understand their basic concepts. Forwards are contracts between two parties to buy or sell an underlying asset at a predetermined price on a future date. These contracts are customizable and can be tailored to meet the specific needs of the parties involved.
Swaps, on the other hand, involve the exchange of cash flows or liabilities between two parties. They are often used to manage interest rate risks or currency exchange rate risks. For example, a company with a loan tied to a variable interest rate might enter into an interest rate swap to convert the variable interest rate into a fixed rate, providing more certainty in future interest payments.
The Role of Derivatives in the Financial System
Derivatives play a crucial role in the financial system by providing various benefits to market participants. They facilitate price discovery, allowing investors to assess the market’s expectations of future asset prices. They also enhance market liquidity by providing opportunities for buyers and sellers to enter and exit positions.
Additionally, derivatives enable efficient risk management and hedging strategies. Businesses can use derivatives to mitigate risks associated with fluctuations in commodity prices, interest rates, foreign exchange rates, and more. By hedging their exposures, companies can focus on their core operations with reduced uncertainty.
However, it’s important to note that derivatives can also introduce risks, particularly when used for speculation or when there is inadequate understanding or control of the associated risks. Excessive reliance on derivatives without proper risk management can lead to significant financial losses and market disruptions, as witnessed during the global financial crisis in 2008.
