scorecardresearch

Derivatives offer effective & low-cost way to transfer risk

While common investors are familar with basic assets of trading like equity, fixed-income instrument, currency…

While common investors are familar with basic assets of trading like equity, fixed-income instrument, currency and commodity markets, they are less familiar with derivatives. Derivative markets are those financial instruments that derive their values from the performance of these basic assets. Let us understand the nuances of derivatives as a risk management tool.

What is derivative?

A derivative is a financial instrument that derives its value from the values of some underlying assets. It is similar to insurance, which allows the transfer of risk from one party to another. Derivatives, too, allow for the same type of risk transfer.

The most common derivatives are equities, fixed- income securities, currencies and commodities, but the other derivatives include interest rates, credit, energy and weather, all of which are not generally thought of as assets.

Thus, like insurance, derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset. Like insurance, derivatives, too, have a definite life span and expire on a specified date.
Classes of derivatives

There are two general classes of derivatives. Some provide the ability to lock-in a price at which one might buy or sell the underlying. Because they force the two parties to transact in the future at a previously agreed-upon price, these instruments are called forward commitments. Various types of forward commitments are called forward contracts, futures contracts and swaps. Another class of derivatives provides the right, but not the obligation to buy or sell the underlying at a pre-determined price. Because the choice of buying or selling versus doing nothing depends on a particular random outcome, these derivatives are generally called options.
Advantages of derivatives

Derivative markets create opportunities for the individual and institutional investors. It can be used to create strategies that cannot be implemented with the underlying assets alone. For instance, derivatives make it easier to go short, thereby, benefiting from a fall in the value of the underlying assets. In addition, derivatives are characterised by a higher degree of leverage, which means participants in derivatives usually have to invest only a small amount of capital relative to the value of the underlying assets. As a result, small movements in the underlying assets can lead to a fairly larger movement in the amount of money made or lost on the derivative. Derivatives generally trade at lower transaction costs than the spot market transactions, and are often more liquid than the underlying assets, and offer a simple but effective, and low-cost way to transfer risk.

For instance, an individual or an institutional shareholder can reduce or even completely eliminate the market exposure by trading a derivative in equity. Holders of fixed-income instruments can use derivatives to reduce or completely eliminate interest rate risk, so that they can focus only on the credit risk. Derivatives permit such adjustments easily and quickly.
Risk management tool

Risk management is a dynamic and ongoing process, reflecting the fact that the risk assumed can be difficult to measure and is constantly changing. So, derivatives are tools that make it easier to manage risk. Although one can trade shares, bonds and any other underlying assets to adjust the level of risk, it is always more effective to trade derivatives.

Value addition
* Derivatives are similar to insurance products, which allow the transfer of risk from one party to another
* A small movement in the underlying assets can lead to a fairly large movement
in the amount of money made or lost on derivative
* An individual or an institutional shareholder can reduce or completely eliminate the market exposure by derivative trading

The writer is an associate professor of finance and accounting at IIM, Shillong

For Updates Check Personal Finance news; follow us on Facebook and Twitter

Get live Share Market updates and latest India News and business news on Financial Express. Download Financial Express App for latest business news.