Applications of Derivatives

 Participants in the Derivatives Market

As equity markets developed, different categories of investors started participating in the

market. In India, equity market participants currently include retail investors, corporate

investors, mutual funds, banks, foreign institutional investors etc. Each of these investor

categories uses the derivatives market to as a part of risk management, investment strategy or

speculation.

Based on the applications that derivatives are put to, these investors can be broadly classified

into three groups:

· Hedgers

· Speculators, and

· Arbitrageurs

Hedgers

These investors have a position (i.e., have bought stocks) in the underlying market but are

worried about a potential loss arising out of a change in the asset price in the future. Hedgers

participate in the derivatives market to lock the prices at which they will be able to transact in

the future. Thus, they try to avoid price risk through holding a position in the derivatives

market. Different hedgers take different positions in the derivatives market based on their

exposure in the underlying market. A hedger normally takes an opposite position in the

derivatives market to what he has in the underlying market.

Hedging in futures market can be done through two positions, viz. short hedge and long hedge.

Short Hedge

A short hedge involves taking a short position in the futures market. Short hedge position is

taken by someone who already owns the underlying asset or is expecting a future receipt of the

underlying asset.

Long Hedge

A long hedge involves holding a long position in the futures market. A Long position holder

agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward

price. This strategy is used by those who will need to acquire the underlying asset in the future.

For example, a chocolate manufacturer who needs to acquire sugar in the future will be worried

about any loss that may arise if the price of sugar increases in the future. To hedge against this

risk, the chocolate manufacturer can hold a long position in the sugar futures. If the price of

sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal

market, but he will be compensated against this loss through a profit that will arise in the

futures market. Note that a long position holder in a futures contract makes a profit if the price

of the underlying asset increases in the future.

Long hedge strategy can also be used by those investors who desire to purchase the underlying

asset at a future date (that is, when he acquires the cash to purchase the asset) but wants to

lock the prevailing price in the market. This may be because he thinks that the prevailing price

is very low.

Speculators

A Speculator is one who bets on the derivatives market based on his views on the potential

movement of the underlying stock price. Speculators take large, calculated risks as they trade

based on anticipated future price movements. They hope to make quick, large gains; but may

not always be successful. They normally have shorter holding time for their positions as

compared to hedgers. If the price of the underlying moves as per their expectation they can

make large profits. However, if the price moves in the opposite direction of their assessment,

the losses can also be enormous.

Arbitrageurs

Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous

trades that offset each other and capture a risk-free profit. An arbitrageur may also seek to

make profit in case there is price discrepancy between the stock price in the cash and the

derivatives markets.

For example, if on 1st August, 2009 the SBI share is trading at Rs. 1780 in the cash market and

the futures contract of SBI is trading at Rs. 1790, the arbitrageur would buy the SBI shares

(i.e. make an investment of Rs. 1780) in the spot market and sell the same number of SBI

futures contracts. On expiry day (say 24 August, 2009), the price of SBI futures contracts will

close at the price at which SBI closes in the spot market. In other words, the settlement of the

futures contract will happen at the closing price of the SBI shares and that is why the futures

and spot prices are said to converge on the expiry day. On expiry day, the arbitrageur will sell

the SBI stock in the spot market and buy the futures contract, both of which will happen at the

closing price of SBI in the spot market. Since the arbitrageur has entered into off-setting

positions, he will be able to earn Rs. 10 irrespective of the prevailing market price on the expiry

date.