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Q1. What are derivatives? How are they used to hedge risk?


Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, commodities (like wheat), stocks and bonds. The term ‘derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the cash asset; e.g., price of a stock option depends on the underlying stock price and the price of currency future depends on the price of the underlying currency.


A derivative contract or product, or simply ‘derivative’, is to be distinguished from the underlying cash asset, i.e. the asset bought/sold in the cash market on normal delivery terms. The price of the cash instrument is referred to as the ‘underlying’ price. Examples of cash instruments include actual shares in a company, commodities (crude oil, wheat), foreign exchange, etc. There are two types of derivative securities that are of interest to most investors- futures and options.

Future contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. The party which agrees to purchase the asset is said to have a long position and the party which agrees to sell the asset is said to have a short position.

An Option is the right but not the obligation of the holder, to buy or sell underlying asset by a certain date at a certain price. The option represent a special kind of financial contract under which the option holder enjoys the right (for which he pays a price), but has no obligation, to do something.

There are two basic types of options: call options and put options.
A call option gives the option holder the right to buy a fixed number of shares of a certain stock, at a given exercise price on or before the expiration date. To enjoy this option, the option buyer (holder) pays a premium to the option writer (seller) which is non-refundable. The writer (seller) of the call option is obliged to sell the shares at a specified price, if the buyer chooses to exercise his option
A put option gives the option holder the right to sell a fixed number of shares of a certain stock at a given exercise price on or before the expiration date. To enjoy this right, the option buyer (holder) pays a non-refundable premium to the option seller (writer). The writer of the put option is obliged to buy the shares at a specified price, if the option holder chooses to exercise the option.
Options and futures contracts are important to investors because they provide a way for investors to manage portfolio risk. Investors incur the risk of adverse currency price movements if they invest in foreign securities, or they incur the risk that interest rates will adversely affect their fixed-income securities (like bonds).
Options and futures contracts can be used to limit some, or all, of these risks, thereby providing risk-control (hedging) possibilities. For example, if you are holding Reliance shares, you can hedge against falling share price by purchasing a put option on the Reliance shares.
Speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk.

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