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What is a derivative?

Lets assume that you are an active observer of the stock market. Over the past few sessions you have been observing that the stock market has been continuously rising and you are of the opinion that a few stocks (if not more) have run up excessively and are clearly overvalued in today’s scenario. How can you now profit from this knowledge?

Fundamentally, there are two ways:

1. Short Sell the stock – Short-selling essentially means that you enter into an agreement to sell a particular asset without owning it. How can you do that? Lets say that today stock X is trading at Rs. 100, whereas you think that its actual value should be around Rs. 80. You can now enter into a short-selling arrangement wherein you agree to sell someone 100 shares of Stock x at today’s price of Rs. 100 (even when you don’t own the stock). In this agreement you also specify when will the actual delivery of shares take place. Lets say the delivery is two weeks from now. At the end of two weeks, if the stock actually behaved as you expected, its price should have come down to Rs. 80. You can now purchase 100 shares of Stock x from the market at Rs. 80 and deliver it to the person with whom you entered the agreement with. Thus, you made a cool profit of Rs. 2000 (Rs. 20 X 100) without even owning the stock.

2. The other way of profiting from this situation is to enter into derivative contract. Simply put, a derivative is something which derives its value from an underlying. Lets see 2 ways of using a derivative instrument in the present situation:

a. Entering into a futures contract – Two parties enter into a transaction to buy/ sell a particular asset at a certain date in the future, at a market determined price. In our example, you can enter into a futures contract with someone agreeing to sell Stock x at Rs. 100, two weeks from now. Futures contracts are typically cash settled. So, at the end of two weeks, if the stock has indeed dropped to Rs. 80, you will be getting Rs. 2000 from the buyer of your futures contract (Please note that this is unlike the short-selling example described above, wherein you will need to physically deliver the stocks, though the net effect is the same)

b. Entering into an options contract – What happens if the stock moves against your expectations? In our case, if the stock moves up to Rs. 120, then instead of making a profit of Rs. 2000, you will end with a loss of Rs. 2000. “Options” is an instrument which can help you out of this situation. An options contract gives the buyer, the right but not the obligation to exercise a particular choice. So, in our example above, you could have entered into an options contract to sell Stock X at Rs. 100 by paying an “Options premium”. If on the delivery date, if Stock X is quoting below Rs. 100 you can exercise your option and sell it at Rs. 100. However, if Stock X is trading above Rs. 100 then you are better off selling it in the market. So you can choose not to exercise your option.

Derivatives can be a great tool for hedging and financial structuring if used rightly. However, it can have disastraous effects when used short-sightedly as many have come to realize with the current financial meltdown. More of it in a future post..

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  1. Derivatives are financial instruments whose value changes in response to the changes in underlying variables. A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.