• How Derivatives are used to minimize risk?

    The derivative market instruments were introduced to hedge risks as well as to satisfy the speculative needs of the investors.

    Hedging

    One use of derivatives is to be used as a tool to transfer risk by taking the opposite position in the underlying asset. Suppose someone has some stocks of a particular company in his account and has a fear that the stock price may decrease in future. So he will go for short on its future to reduce his risk.

    Pratical Implication: Most of the Indian software companies insulated themselves from the dollar value fluctuations by hedging the dollar. Since a majority of the revenues for these companies is in dollar terms, they suffered huge losses when the dollar considerably depreciated against all currencies (including the Indian rupee). Hence, the companies hedged the dollar at a particular price so that they were guaranteed to get a minimum exchange rate for the dollar irrespective of the dollar rate fluctuations in the future.

    Speculation and arbitrage

    In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. In addition to outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.

    How is the futures market linked to the spot market? An explanation

    To understand the link between the prices in the futures market and the spot market, let us consider a hypothetical example:

    Stock X is trading at Rs.1000 on the spot market (NSE). The price of the stock in the futures market (NSE 1 month futures index) is Rs.1012. Essentially, what this means is that stock X future can be bought at Rs.1012.

    How arbitrage works?

    Now consider that there is wide disparity between the spot and the future price of Stock X (spot price Rs.1000 and future price Rs.1030).

    A trader T now buys 1 stock in the spot market and sells the stock in the futures market.

    Stocks owned: 1 spot buy at 1000 and 1 future sell at 1030.

    Now at the time of the future expiry there could be 3 scenarios:

    Stock trading at below 1000 (Rs.990): The trader suffers a loss of Rs.10 in the spot market but a profit of Rs.40 in the futures market and hence an overall profit of Rs.30
    Stock trading at above 1030 (Rs.1040):

     

    The trader earns a profit of Rs.40 in the spot market but a loss of Rs.10 in the futures market and hence an overall profit of Rs.30
    Stock trading at above 1000 but below 1030 (Rs.1020): The trader earns a profit of Rs.20 in the spot market and a profit of Rs.10 in the futures market and hence an overall profit of Rs.30

    Thus, in all the scenarios the trader is always earning a profit of same amount. Such a situation is termed as arbitrage trading. To avoid this, there is always a link between the spot and the futures market such that the disparity of the prices in the two markets is not high. Thus an increase (or decrease) in price of the stock in futures market would pull (or plummet) the spot price.

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