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Life with and without derivatives: (Understanding Derivatives - Part I) - Views on News from Equitymaster
 
 
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  • Jun 8, 2000

    Life with and without derivatives: (Understanding Derivatives - Part I)

    As if there were not enough things to worry about...

    The capital market is a complex world. One is flooded with so many diverse opinions and vague theories that at times people throw up their hands in despair. Now we have one more phantom to grapple with - the phantom of derivatives. Often one wonders as what exactly is hedging. How does a product that seems like a pure gambling tool help an investor? Below here, we narrate a small story how Savitri uses a pure betting tool to eliminate her risk.

    An example in use of hedging mechanism

    Savitri is a forty-year-old lady who sells homemade papads for a living. Though not highly educated she was a shrewd lady who knew her business and the ways of the world.

    She faced a problem that was not unique to her alone. As one would understand, papads need to dry after rolling them. Savitri had no other source of income apart from the papads she made and sold. But come rains, there was no way she could make the papads since they would get spoilt if it rained in the few hours she had left the papads out to dry.

    It was the 16th of May. Savitri had prepared the dough for the papads and rolled them out. She only had to put them out to dry. Then in the news, she heard that there was some chance of pre-monsoon showers the following day. Caught in a bind, she thought up a ruse, which she felt, if properly implemented, could assure her that she could safely make papads throughout the monsoons.

    No, she did not dream up some new technology. She just did some financial jugglery. To understand the same, read onů

    Savitri first made a cost estimate how much the dough has cost her. She estimated that she had spent seventy-five rupees on the ingredients and another twenty-five as her personal labour. If it did not rain, she would be selling the papads for four hundred rupees. After having done this estimate, she goes for a casual chat with Jayesh.

    Mr. Jayesh, one of Savitri's neighbors, was an inveterate gambler. Savitri knew of his weakness to lay a wager to resolve any argument. In due conversation with Jayesh, they "happen" to enter into an argument regarding the weather forecasts by the Indian Meteorological Department as being rather unreliable. They eventually decided to lay a bet. Savitri had "predicted" that it will rain the next day and Jayesh remained insistent that it wouldn't rain the next day. The stakes were decided by Savitri as one hundred rupees.

    Now, let us see what has Savitri gained out of this entire arrangement. Let us assume that Savitri "wins" the bet and it does rain. As the first effect, she will lose out her entire investment she had made in papads, i.e., Rs100/-. But she wins the bet she had laid with Jayesh. So she gets back her basic investment plus the labour she had put in. Therefore, this arrangement made her position more secure than before.

    Let us now see what had happened, had she lost the bet. In this case, she has to pay her dues to Jayesh. She thus loses hundred rupees in the bargain. But she can merrily sell her papads and earn four hundred rupees and maintain a profit of two hundred rupees.

    (Figures in Rs)
    Scenario Rains No Rains
    Gain (Loss) in Papad (Rs 100) Rs 300
    Gain (Loss) in Bet Rs 100 (Rs 100)
    Net Gains - Rs 200

    Therefore, with the help of some clever financial jugglery, she has transferred her risk to Jayesh. This transfer of risk has cost her some money, but it makes her income more certain and considerably eliminates the chances of losses due to rains.

    Now, with this kind of arrangement, Savitri can make papads for almost throughout the year and is earning a more regular income than ever before.

    Here we have seen how Savitri has covered her risk. The use of index futures is very similar to the example mentioned above. But one must be careful to note that betting on rains is by no means a derivative. The difference between betting on rain and using a real derivative will be clearer in the story that follows...

  • This article is one of four articles in a series to understanding derivatives. Read Part II, Part III and Part IV of this series

     

     

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