Protect your Portfolio: Exploring the Power of Derivatives
Protect your Portfolio: Exploring the Power of Derivatives
What is a Derivative Contract?
The landscape of investments is ever-evolving. It is important, as investors, that we find new and profitable avenues to invest in and expand our portfolio both for increased profits and for risk mitigation. One tool to protect our investments is use of derivatives. In this blog, let us explore and understand Derivatives and learn deeply about Options and Futures.
To understand the power of Derivatives, we must first understand what a Derivative Contract is. A derivative contract is simply a financial agreement between two parties that derives value from an underlying asset or index. The underlying assets are most commonly stocks, bonds, interest rates, commodities, market indices and currencies. The terms of the contract detail the agreed-upon price, expiration date and settlement conditions. Derivatives are predominantly used for hedging against risk and gaining exposure to financial instruments without owning them. Of all derivative products, options and futures are amongst the most common and popular types of derivatives.
Options Contracts:
Let us now take a look at what Options Contracts are and understand them. What is an options contract? It is a contract that offers an investor the right but not an obligation to buy or sell an underlying asset at a pre-determined price and within a specified time frame. How is this beneficial? Well, it gives investors the flexibility to capitalise on market trends without the need for substantial capital. The terms of each contract will specify the underlying asset, the specified price and a specified expiration date. Since options are generally less expensive than the underlying assets, they can be used for both speculating and hedging. This allows an investor to decide to bet on a stock without having to buy or sell the asset. To enjoy this privilege, the buyer pays a premium to the selling party of the option through the broker.
Futures Contracts:
Now that we have understood what Options Contracts are on the fundamental level, let us now learn about Futures contracts. A futures contract is an agreement between two parties to buy or sell an underlying asset at a pre-determined future date and price. Futures contracts are often used to mitigate risk by hedging. Both the buyer and the seller are under obligation to purchase and deliver respectively on the date of expiration, regardless of the price on the expiration date. Futures too are used to speculate and hedge, and are therefore helpful in reducing losses from unfavourable price changes.
Many commodity prices usually move in predictable patterns, enabling speculators to invest in Futures Contracts because of possible profits.
An Example of a Derivative Contract:
Let’s say an Indian business intends to import $100,000 worth of goods from the US in three months. And suppose, right now, one USD is worth 75 INR.
Without hedging, the cost of importing the goods would rise from ₹75,00,000 to ₹80,00,000 in three months if the exchange rate deteriorates to
1 USD = 80 INR. This would result in a ₹5,00,000 loss due to the unfavourable movement in the exchange rate.
The business chooses to sign a currency forward contract as a hedge against this risk. They purchase a forward contract at the current exchange rate of 1 USD = 75 INR in order to purchase $100,000 USD. Assume for the moment that the forward contract will cost ₹50,000.
The forward contract’s value would rise in three months if the exchange rate deteriorates to 1 USD = 80 INR. Assume that it rises by ₹4,00,000. The company would have to pay ₹50,000 for the forward contract in this instance, but the contract’s increased value makes up for the ₹5,00,000 loss they would have otherwise incurred from the unfavourable movement in the exchange rate.
Thus, the company effectively reduces the risk of unfavourable exchange rate movements and safeguards its bottom line by hedging with the forward contract.
How are Derivatives Useful?
Derivatives play an important role in protecting your investments in the long run. Here’s why:
Risk Management: Derivatives allow investors to hedge against various risks such as varying interest rates, forex risk, commodity price risk, etc., For example, a company can use futures to lock in the price of a commodity, thereby protecting against price fluctuations.
Speculation: Derivatives allow investors to speculate on price fluctuations of the underlying assets without actually owning them. Investors can buy options to bet on the future direction of stock/commodity prices.
Price Discovery: Derivatives Markets often provide crucial information about market expectations and future price fluctuations. For example, the price of options gives an idea of the volatility of a stock.
Apart from these, derivatives have other valuable uses, but it is also important to know that prior knowledge and valuable experience as Derivatives too come with a variety of risks.
Who is best suited for Derivatives?
Like any financial opportunity, it is important to learn as deeply as possible about Derivatives before proceeding to hedge. One should have a deep understanding of market trends, risk management and investment strategies before proceeding. Investors who are willing to diversify their portfolios and speculators who are willing to capitalise on short-term market changes may also find Derivatives useful. Before diving into using Derivatives to hedge, beginner investors should seek professional advice and gain an in-depth understanding of the market to both diversify their portfolio and have a solid risk management plan. It is always good to remember that while derivatives create opportunities to make a quick profit, they also carry a heightened level of risk, thus requiring knowledge, careful consideration and due diligence.
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Conclusion:
Derivatives are a powerful yet intricate facet of the financial market, offering investors a diverse range of opportunities for risk management. We have gone through options and futures predominantly and it is clear that a deep understanding as well as a strategic approach is crucial for success. Goodwill Wealth Management offers reliable and comprehensive research insights and helps understand the complexities in the derivatives market. Choose Goodwill Wealth Management today and experience personalized guidance and navigate through the financial market. As the financial landscape continues to evolve, embracing the power of derivatives with a trusted partner like Goodwill Wealth Management as they position investors on a path to resilient and well-informed wealth management strategies.