What Is the Use of Derivatives

Using Derivatives to manage risk better

Why are they called derivatives? Derivates are contracts (they are not assets) whose value is derived from the value of an underlying asset. This underlying asset could be an equity share, a bond, an index, gold, agricultural commodities, oil etc. Remember that stock markets are about risk and you need to manage this risk. Derivatives offer a solid method to manage this risk. Among the many use of derivatives, managing risk is foremost. In other words, risk management and derivatives are the two sides of the same coin. It is one of the most important and also the most intelligent derivatives uses in markets.

When we talk of derivatives and risk management, we are essentially talking about hedging risk. For example, a trader who is long wants to hedge against a fall in price and a trader who is short wants to hedge against a rise in prices. You can also call it derivative hedging or as hedging using the power of derivatives.  Managing risk is one of the most primary and primordial uses of financial derivatives in the financial markets. To translate derivatives into market friendly terms, they are popularly used as futures and options.

In this section we shall look at derivatives risk management but will also look at some of the other uses and applications of derivatives in the financial markets. Derivatives management is all about using the power of futures and options to enhance the risk adjusted returns. That is the core purpose of intelligent investing after all.

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What All Is Covered Under Derivatives?

When we talk about derivatives at a conceptual level, there are four products viz. forwards, futures, options and swaps. Our focus would be on futures and options as they are exchange traded. However, before further on derivatives, it makes sense to understand the different types of derivative products available.

Forwards

1. : A forward is a contractual agreement between two parties to buy or sell an underlying asset at a fixed future date for a fixed price that is pre-decided on the date of contract. There is a buyer and a seller in any forward contract and both parties are obliged to honour their side of the commitment. Remember that forwards are over-the-counter (OTC) products. That means they are private contracts and not traded on an exchange platform. Forwards are, hence, non-standardized and hence risky and illiquid.

Futures

1. : Structurally, a futures contract is almost the same as a forward contract. Like in forwards, even in futures, both the buyer and the seller have to mandatorily fulfil their side of the obligation. There is an important difference in that unlike forwards, futures are traded on an organized exchange and regulated by SEBI. In India, NSE is the largest stock exchange trading futures followed by the BSE. Exchange traded futures in India are standardized in terms of lot sizes and expiry dates of contracts and all futures transactions are counter guaranteed by the clearing corporation of the stock exchange. This totally obviates counterparty risk.

Options

1. : Even options are exchange traded contracts but they are structurally different from futures. In a futures contract, both the buyer and the seller have unlimited upside potential and downside risk. However, in an option, the buyer of the option has the right but not an obligation, to buy or sell the underlying asset. When we talk of option price or option premium, that is actually the price of this right that the buyer enjoys. Option premium is the sunk cost that the buyer pays to the seller for taking the risk of giving the buyer an option. Seller will earn the premium maximum, but losses can be unlimited.

Swaps

1. : This is again an OTC product, which is not traded on the stock exchange. Swaps, as the word suggests, refers to an exchange of streams of cash flows. In swaps, you can swap variable rate interest pay outs for fixed rate interest pay outs or you can exchange dollar payables for pound payables or euro payables.

Before the Uses, Let Us Understand the Derivatives Players

To understand the applications of derivatives, you need to first understand who are the key players in the derivatives markets. They are not like the plain classification of traders and investors like in equity market. There are 3 classes of players in the derivatives market.

• Hedgers are the players in the derivative market who have skin in the game. That means, they have an underlying position and hence want to protect their risk. For example, an investor holding a portfolio of Infosys and TCS will want to hedge against a fall in technology stocks. Similarly, a bond investor holding long dated bonds will want to hedge against a rise in the interest rates. In case of importers, they want to hedge against an appreciation in the dollar. Hedgers are the players who only come to the derivatives market with an underlying exposure. They want to protect losses by getting the F&O markets to compensate if the price moves against them.
• Speculators are traders who trade in futures and options as a proxy for cash market. In the cash equity market, you need to pay the full sum by T+1 date. Instead, some prefer to carry a position by paying a margin in futures. Even with the MTM margins, it does work out cheaper, since the margins payable are lower than the cost in the equity market. Speculators trade on small margins to make profits but they also take a risk as these are leveraged positions.
• Finally, arbitrageurs are the safe players who arbitrage differences between the spot cash market and the futures market. If a stock is quoting at Rs500 in the spot market and at Rs504 in the futures market, then there is an assured return of 4 if you buy in spot and sell in futures. That is nearly 0.8% in a month or close to 10% in a year. That is considered fabulous returns for a riskless arbitrage transaction. These arbitrageurs bring about better pricing through working on such price gaps.

WHAT ARE THE USES OF DERIVATIVES

The derivatives market or the futures & options market has a critical role to play in the overall scheme of things. Here are some major contributions made by the derivatives market.

• The most important role played by derivatives is that they allow the distribution of risk. Traders and investors with lower risk appetite can hive off the risk to another party with higher risk appetite for a price. That is what derivatives is actually all about.
• Derivatives market enable intelligent and scientific price discovery based on actual valuations and expectations. Spot prices are nothing but the expected futures prices and that missing link in the pricing equation is provided by the derivatives market
• Derivatives markets help to transition speculative and other trades from unorganized market to organized market. Unlike the OTC markets, the exchange traded derivatives markets are better regulated, lower on risk and trades are guaranteed.
• Derivatives are an important tool for managing risk. In his book Against the Gods, Bernstein points out that most of the progress in the last 100 years is due to a better understanding and a better ability to manage risk. Derivatives has helped in this.
• Derivatives also act as value enhancers of business. Whether you hedge your portfolio or whether the business hedges its risk, the reduced risk is a direct boost to the valuations since future cash flows are always calculated by discounting with risk capital.
• At a very fundamental level, derivatives as tools of speculation, have the advantage of offering leveraged trades without getting into leverage. Typically, leverage has implications for your solvency and credit standing. Derivatives are off balance sheet items and that works in favour of using derivatives for speculation. However, this also has a downside risk.
• Cash futures arbitrageurs provide finer quotes, narrow the spreads and the lower bid-ask spreads makes the market more liquid. This is true of options arbitrage also. This improve spreads, brings about more healthy liquidity in the markets.
• It is said that option valuation offers an alternate approach to company valuations since the equity is also, to a large extent, an option on the assets and liabilities of the company.

While there are innumerable uses of derivatives, it must be kept in mind that derivatives are essentially hedging products and that is what they must be used for. When derivatives are used for speculation, the upsides do get magnified but it also means that downsides can also get magnified. Derivatives may not be the weapons of mass destruction as Buffett called it, but as we have seen in the past, derivatives risks are substantial.