LEARNING CENTER
Level | Advanced
What is a derivative? How do mutual funds use derivatives?

Have you noticed that the value of a ticket to the cinema is linked to the popularity of the movie currently showing? You may have noticed that when a movie with high ratings, a good star cast and rave reviews is showing, the theatres hike up the price of the tickets; in a reverse situation, when an average or low-rated movie is showing, ticket prices fall. In other words, the price of the ticket is linked to the ‘value’ of the movie.

Derivatives are financial instruments that are similar to movie tickets. In the case of derivatives, the value or price of the derivative is linked to the value of the underlying security that it represents (the movie is replaced by the security in the case of derivatives). For instance, an equity derivative is linked to the value of the equity share it represents.

The underlying security of a derivative can be an index, an equity share, a bond, a currency, or any other security.

Types of derivatives

Broadly speaking, there are four kinds of derivatives – forwards, futures, options and swaps.

Forwards

When two parties decide to transact (say, when one party decides to sell a commodity to the other party) at a future date and at a pre-decided price, they enter into a forward contract. This contract is tailored to their specific transaction and hence cannot be used by any other party; that is, it cannot be traded or listed on a stock exchange.

Here’s an example of forward contracts. Let’s say you plan to grow 1,000 kilos of rice next year. You can either sell your rice at the price applicable at the time of harvest or fix a price now by selling a forward contract that obligates you to sell 1,000 kilos of rice to a rice buyer after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling rice prices. On the other hand, even if prices rise, you will only get what your contract entitles you to.

Similarly, the rice buyer might want to purchase a forward contract to lock in prices and control his costs. However, he might end up overpaying or (hopefully) underpaying for the rice, depending on the market price when he takes delivery of the rice.

Futures

A future is a contract in which the buyer is obligated to purchase or seller is obligated to sell the underlying security at a pre-decided future date and price. Unlike forward contracts (which are customized contracts), futures contracts are standardized and traded on stock exchanges.

Let’s understand futures with an example. Assume you purchase a rice future on 1 March 2017 at a price of Rs.10,000 and pay a margin of 5%, that is, Rs.500 (5% of Rs.10,000). Assuming the price of the rice future is Rs.11,000 on 1 June 2017, your gain is Rs.500 (Rs.11,000 less Rs.10,000 less Rs. 500 margin). As your investment is only Rs.500, your return is 100% (Rs.500 as a percentage of Rs.500) for three months (1 March to 1 June). Of course, if the price of rice had gone down, the rice future would also have corrected proportionately and you would face the prospect of a similar loss.

In the above example, assume that instead of buying the future, you purchase rice stock by paying the full amount of Rs.10,000. On 1 June 2017, at a price of Rs.10,500, you make a profit of Rs.500. On an investment of Rs.10,000, this works out to 5% as opposed to 100% if the rice future had been purchased.

Options

An option is a contract which offers the buyer the right to buy or sell the underlying security at a pre-decided price (strike price) on or before a pre-decided date (exercise date). However, the buyer is not obligated to exercise the option. He can simply let the option lapse, in which case he will lose the premium he paid to purchase the option.

Options are of two kinds – call options and put options.

Call and put options

If an option buyer expects the price of a currency/stock/index (underlying security) to move up, he can buy a ‘call’ option. A call option gives the buyer the right to buy the underlying security at a pre-decided price on or before a pre-decided date. If the price of the security goes up, the buyer exercises his option and books the profit. However, if the price of the security does not move up as the buyer expects or, perhaps, moves down, the buyer need not exercise the option. He can merely let the option lapse. In this case, all the buyer loses is the option premium he paid.

If an option buyer expects the price of a currency/stock/index to move down, he can buy a ‘put’ option. A put option gives the buyer the right to sell the security at a pre-decided price on or before a pre-decided date. If the price of the underlying goes down, the buyer exercises his option and books the profit. However, if the price of the security does not move down as the buyer expects or, perhaps, moves up, the buyer need not exercise the option. He can merely let the option lapse. In this case, all he will lose is the option premium he paid.

Let’s understand call options with an example. Assuming the value of USD-INR on 1March 2017 is Rs.65 and you buy the USD-INR currency call option for an exercise price of Rs.65.00 for April 2017 at a premium of Re1. On 25 April 2017, assume USD-INR has moved up to Rs.66.40; your call option would now be quoted at approximately Rs.1.50.

The option price of Rs.1.50 has two components – intrinsic value and time value. As USD-INR is at Rs.66.40 and you have the right to buy USD-INR at Rs.65.00, Rs.1.40 of the Rs.1.50 is the intrinsic value (Rs.66.40 less Rs.65). Balance 10 paise is attributable to the time value, which is that portion of the option premium that is attributable to the time remaining until expiration of the options contract.

If you were to sell your call option on 25 March, you would realize Rs.1.50 against an investment of Re1.00 (i.e. a gain of 50% in 55 days).

Assuming the USD-INR goes down instead and is at Rs.64 on 25 April, your call option of Rs.65.00 would be quoted at a meager 2 paise. You would have lost 98 paise of the Re1.00 paid. However, under no circumstances would you lose more than the premium paid.

Swaps

A swap is a contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount to which both parties agree. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. This is normally done to hedge interest rate risks or take a position based on expectation of a change in principal prices. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.

Let’s understand swaps with an example. ABC Company issues Rs.100 crore in 10-year debentures with a variable interest rate of LIBOR (London interbank offered rate) + 2%. LIBOR is currently 2.5%, so Company ABC pays bondholders 4.5%. Two years after selling these debentures, ABC Company fears that LIBOR may increase and consequently its cost of servicing these bonds to rise. ABC Company wants to protect itself from this possibility so it enters into a swap arrangement with PQR, who is an investor.

ABC Company agrees to pay PQR 5% on Rs.100 crore for the balance of 13 years. PQR agrees to pay ABC Company LIBOR + 2% on Rs.100 crore per year for the balance of 13 years.

As PQR holds a contrary view that LIBOR will go down, he is willing to accept fixed rates from ABC Company. Consequently, ABC Company and PQR enter into a swap of the future interest payments wherein PQR is willing to buy the stream of interest payments at this variable rate and pay a fixed amount for each period. At the time of the swap, the amount to be paid over the life of the debt is the same.

PQR is betting that the variable interest rate will go down, lowering his interest cost, but the interest payments from ABC Company will be the same, allowing PQR to pocket the difference.

Uses of derivatives

Derivatives are used for three broad purposes – hedging, speculation and arbitrage.

Hedging

Assume a fund holds stock of ABC Ltd and expects the price to fall temporarily. If it continues holding the stock, the price drop will affect the fund’s performance temporarily. The fund can protect itself by selling an ABC Ltd future, which will hedge the price fall of the stock. Once the price has fallen, the ABC Ltd future is sold, netting a profit equivalent to the temporary loss incurred in the stock of ABC Ltd.

Speculation

You can also speculate using derivatives by taking bullish/bearish positions in the underlying security via futures and options instead of buying/selling. You may not hold ABC Ltd but expect its price to fall. You can sell an ABC Ltd future or buy its put option. When the price falls, you can square up your position, netting a profit. As investment via margin/premiums is lower vis-à-vis buying/selling the underlying, the profit/loss is also higher.

Arbitrage

You can also use derivatives to exploit market inefficiencies. This can be done by benefitting from differential prices between markets. Say ABC Ltd is available at Rs.21 on the Bombay Stock Exchange (BSE) and Rs.22 on the National Stock Exchange (NSE) at the same time on the same day. You can buy the stock on BSE and sell it on NSE to book a profit of Re.1 per share (assuming you don’t need to incur any transaction costs such as brokerage fees or taxes). This exercise is termed ‘arbitrage’.

Mutual funds using derivatives

The Securities and Exchange Board of India (SEBI) permits mutual funds to use derivatives for hedging purposes. The mutual fund can hedge its equity investments using derivatives. Besides this, Derivatives are also used for arbitrage strategies by mutual funds.

Derivatives are versatile and complex instruments that have multiple uses. However, they can also be highly risky. It’s important to use these instruments wisely and smartly to benefit from them. Consult your financial advisor for advice on whether derivatives should be part of your portfolio.

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Key Takeaways

  • A derivative is a financial instrument whose value/price is linked to the value of the underlying security that it represents.
  • The underlying security of a derivative can be an index, an equity share, a bond, a currency, or any other security.
  • Broadly speaking, there are four kinds of derivatives – forwards, futures, options and swaps.
  • A forward contract is a customized contract in which two parties decide to transact at a future date and a pre-decided price.
  • A future is a standardized contract in which the buyer is obliged to purchase/seller is obliged to sell the underlying security at a pre-decided future date and price.
  • An option is a contract which offers the buyer the right to buy or sell the underlying security at a pre-decided price (called the strike price) on or before the pre-decided date (called the exercise date).
  • A swap is a contract in which two parties exchange income on financial instruments.
  • Derivatives are used for three broad purposes – hedging, speculation and arbitrage.
  • SEBI permits mutual funds to use derivatives for hedging purposes.