We often hear people say that the market is quite volatile. But share markets are not so risky to survive. To make the most of your money and your choices, educate yourself to make intelligent decisions. One among the jargons many of us are not very clear about is ‘Derivatives’. How many of us can confidently define it? When someone starts explaining it for us, we soon start losing interest because of the complexity. But trust me, these are not that complex as they look. Let’s start by defining it.
Derivatives
There are lots of definitions available for the term ‘Derivatives’ but those are appreciated when learned by heart in order to impress the other person. In simple terms derivatives are those instruments that an investor uses to speculate and hedge his investments. It is a contract between two or more parties, based on the underlying assets. Its value, driven by fluctuations in the underlying asset.
Purpose of derivatives is very simple. It is like an insurance policy that an investor buys in case the markets fall. If the markets are bearish, our investor gets a bumper profit that puts him out of the cost of purchasing that derivative. It is a contract between two parties which specifies conditions that help make payments between them. Derivatives get their name as they are “derived” from underlying assets such as stocks, contracts, swaps, etc. Conditions that decide the timing of payment usually include the price of the underlying asset and the date at which the particular asset achieves that price.
There are four types of derivatives namely Forwards, Futures, Options and Swaps.
Benefits of having derivatives in a portfolio
- Futures prices are less volatile than securities prices. Stocks have greater downside risk than commodities. If the stocks and bonds portfolio is doing bad, derivatives could be doing good.
- On a risk adjusted basis that means the risk involved in producing returns (usually expressed as rating or number) both derivatives and stocks + bonds portfolio is found to have identical returns.
- Will you be surprised to know that both derivatives and stock + bond portfolio are negatively correlated? If one does good, other might do bad and vice versa. It is therefore advisable to hold a portfolio with a mix of both for hedging purposes.
- We know very well that when inflation peaks up, the share markets dwindle. It means that inflation has negative correlation with stocks (but not bonds). Whereas, inflation has a positive correlation with derivatives. As inflation increases, the value of the derivatives increase and vice versa.
I hope this article helps you overcome your fear of derivatives. It is always advisable to build a portfolio with a mix of stocks + bonds and a pinch of derivatives so that you reap profits whatever the state of the markets are.
