Derivatives are financial instruments that derive their prices from the performance of other instruments, called underlying assets. For example, underlying assets could be equity, fixed income, foreign currencies, or commodities.
A derivative could also be defined as a contract between two counterparties to exchange payments linked to the prices of underlying assets. Derivatives are classified by their behavior or the type of instrument.
Categories of Derivatives
- Exchange-traded derivatives are those instruments that are traded in a stock exchange.
- Over-the-counter derivatives are instruments created and customized by the parties
involved.
The most common derivatives are futures, forwards, options and swaps.
Derivative instruments traded on a regulated exchange like NSE, BSE, LSE, NSE, etc., are known as Futures and Options. On the other hand, derivatives like Forwards, SWAPs, etc., are available in an Over Counter Market and not traded on an exchange.
Use of Derivative in a Portfolio
There are several types of underlying securities – equity, fixed income, commodities, market indices, currency exchange rates, etc. Because of such a wide variety of underlying securities, investment in derivatives can provide exposure to a wide range of asset classes. As a result, it is cheaper to trade or invest in derivatives than in underlying physical securities.
Investment in derivatives works on the principle of leverage – i.e., investors can take significant exposure to derivatives by investing only a fraction of the amount.
Efficient Asset Allocation and Enhancement of Returns
Derivatives can be used for tactical asset allocation objectives of a portfolio, as they provide access to a wide range of securities and markets at lower transaction costs. Portfolio managers can effectively create a diverse portfolio by investing in derivatives, such as equity or commodity oil derivatives, rather than holding a position in an equity or the commodities market.
As investments in derivatives are made using leverage, they are often used to enhance the portfolio’s returns greatly. As a result, even a small investment can yield great returns, although such decisions are usually made for the short term. For example, a portfolio manager can invest in equity options to gain higher exposure to a particular sector.
For international investments, portfolio managers can invest in currency or certain commodity derivatives to gain from favorable currency movements to benefit from a price movement in the forex or global commodity market.
Risk Management
Derivatives are typically used for hedging systematic or market risks such as currency fluctuations, market movements, interest rate movements, inflation, etc. These risks are inherent in the securities and cannot be diversified away. Derivatives provide a cheaper way to reduce such risks.
In cases of international investing, portfolio managers are exposed to currency exchange rate fluctuations. As a result, they often use currency derivatives like futures, options, and swaps to hedge foreign exchange risk.
Equity options are commonly used to hedge against the undesired movement in the price of equity shares. In addition, interest rate swaps are used to hedge the risk due to the direction of interest rates.
Management of Fund Flows
Fund inflows and outflows are not constant in a portfolio and might hamper a portfolio manager’s investment strategy in the short term. Fund managers may invest the incoming cash in market index derivatives to not miss out on any action in the market. This is called the equitization of money.
Cost Management
As we already saw, derivatives provide a cheaper way of gaining exposure to financial securities. Therefore, portfolio managers use them to reduce the cost of their investment and invest in various asset classes.
Bottomline: Derivatives Are Useful for Both Price Discovery and Portfolio Optimization
Derivatives are financial securities that obtain their value from another financial security. Forwards and futures are agreements to enter into a transaction to buy or sell a product at a particular price to be done at a future date. The main difference is that forwards are traded Over The Counter, while futures are exchange-traded.
Derivatives available on different underlying assets could be traded to take advantage of price movement and as an additional asset class in an investment portfolio to get extra returns. The initial investment required in derivatives could be lesser than the cash segment’s actual position. This is due to the margin or premium amount that is a fraction of the contract value.
Derivatives are innovative financial instruments that provide retail and institutional traders opportunities.
