Financial Derivatives

. WHAT ARE DERIVATIVES?

"Instruments derived from securities or physical markets".

The most common types of derivatives that ordinary investors are likely to come across are futures, options, warrants and convertible bonds. Beyond this, the derivatives range is only limited by the imagination of investment banks.

Derivative Example – Sensex

The value of sensex is derived from 30 companies listings.

2. WHAT IS THE DIFFERENCE BETWEEN DERIVATIVES AND SHARES?

The subtle, but crucial, difference is that while shares are assets, derivatives are usually contracts. we can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually be fairly standardised and governed by the property or securities laws in an appropriate country.

On the other hand, a contract is merely: an agreement between two parties, where the contract details may not be standardised.



The main feature in derivatives is sophisticated management of risk. The feature that gets people excited, is gearing or leverage

3. What is Gearing?

Gearing. Simply, the ability for derivatives to soar 100% in a few days, when the underlying security has only risen by a far smaller amount (say 10%). There is nothing magical in gearing. Anyone who has a mortgage is geared to the property market.

For Example:

A person buys a house for Rs.100,000; they put up 10,000 and borrow 90,000 from the bank. Six months later, the house is sold for Rs. 150,000. They pay back 90,000+ to the bank they keep Rs.60, 000. Here original investment is 10,000 and profit is 60,000.. The same principle is applicable to many derivatives investments.

4. Short selling and problems.

The reason is probably that we are equating derivatives with investing in shares or houses. (Refer question 2 above). The idea of selling shares or a house that you don't own is not an easy one. And quite rightly so, these are assets, which one usually sells only when one holds title.

By contrast, derivatives are usually contracts, not assets. So the action of shorting is merely that of sitting on one side of a contractual agreement that 9 times out of 10 will be settled with a mere cash exchange.

5. Hedge: Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.



An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).



6. Short Hedge: An investment strategy that is focused on mitigating a risk that has already been taken. The "short" portion of the term refers to the act of shorting a security, usually a derivatives contract, that hedges against potential losses in an investment that is held long (i.e., the risk that was already taken).

If a short hedge is executed well, gains from the long position will be offset by losses in the derivatives position, and vise versa.







A common risk in short hedging is basis risk, or the risk of price levels not changing much over the period the hedge is in place; in this scenario, the asset held in the long position would not gain any value, and the short hedge would lose value.

Short hedging is often seen in the agriculture business, as producers are often willing to pay a small premium to lock in a preferred rate of sale in the future. Also, short hedges involving interest rates are common among institutional money managers that hold large amounts of fixed income securities and are concerned about reinvestment risk in the future.



7. Over-Hedging: A hedged position in which the offsetting position is for a greater amount than the underlying position held by the firm entering into the hedge. While hedging ensures price certainty, over-hedging can in effect become partly a hedge and partly a speculative investment and can unduly hurt a firm.







The over-hedged position essentially locks in a price for more goods, commodities or securities than is required to protect the position held by the firm.

For example, if a firm entered into a January futures contract to sell 25,000 mm Btu at $6.50/mm Btu but the firm had only an inventory of 15,000 mm Btu that they're trying to hedge, but due to the size of the futures contract the firm now has excess futures contracts that amount to 10,000 mm Btu, this would be a speculative investment.





8. Delta Hedging: An options strategy that aims to reduce (hedge) the risk associated with price movements in the underlying asset by offsetting long and short positions. For example, a long call position may be delta hedged by shorting the underlying stock. This strategy is based on the change in premium (price of option) caused by a change in the price of the underlying security. The change in premium for each basis-point change in price of the underlying is the delta and the relationship between the two movements is the hedge ratio.



For example, the price of a call option with a hedge ratio of 40 will rise 40% (of the stock-price move) if the price of the underlying stock increases. Typically, options with high hedge ratios are usually more profitable to buy rather than write since the greater the percentage movement - relative to the underlying's price and the corresponding little time-value erosion - the greater the leverage. The opposite is true for options with a low hedge ratio.



9. Selling Hedge: A hedging strategy with which the sale of futures contracts are meant to offset a long underlying commodity position. Also known as a "short hedge."



This type of hedging strategy is typically used for the purpose of insuring against a possible decrease in commodity prices. By selling a futures contract an investor can guarantee the sale price for a specific commodity and eliminate the uncertainty associated with such goods.



10. Cross Hedge: The act of hedging ones position by taking an offsetting position in another good with similar price movements.



Although the two goods are not identical, they are correlated enough to create a hedged position as long as the prices move in the same direction. A good example is cross hedging a crude oil futures contract with a short position in natural gas. Even though these two products are not identical, their price movements are similar enough to use for hedging purposes.



11. Hedge Street: An internet-based, government-regulated market that allows traders to perform hedging activities or speculate on specific economic events. Binaries and futures contracts are provided on different markets including commodities, currencies, employment, inflation and other economic indicators.



Hedge Street was developed to give the average investor the ability to profit from the outcomes of certain economic events. Hedge Street benefits small investors by having small contract sizes at low prices. HedgeStreet is regulated by the Commodity Futures Trading Commission.