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Your perception of derivatives instrument is... - Views on News from Equitymaster
 
 
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  • Dec 11, 2003

    Your perception of derivatives instrument is...

    With an assortment of investment instruments available in the financial markets, derivatives have caught the attention of investors and their volumes are on the rise. However, since this market is relatively more complicated than the cash market awareness and participation continues to be low as far as retail investors are concerned. Therefore, in order to know as to what an average investor feels about derivatives we conducted a poll and the question asked was, "As an investor, what is your perception about derivative instruments" and the results were as follows.

    Out of the total respondents, 47% voters believe that derivative contracts are just speculation medium, 31% believe it's a hedging tool and 22% believe that it allows one to take higher exposure than cash markets with equivalent initial cash outgo. We shall now briefly discuss the advantages (if any) and the disadvantages of each of the above three means.

    Speculation medium:
    It is strange to know that 47% of the voters believe that derivative instruments are just speculative tools. Speculators can take position in the markets betting on either prices of stocks will go up or come down through derivative contracts. Derivatives if used to speculate can prove extremely dangerous, especially in the futures market, as the person's exposure is already much higher as compared to cash markets because one has to pay just the margin money. Lets take a hypothetical example; say stock A, which currently trades at Rs 1000. The margin money on the same will be around 25%. So the person can take a exposure which is equal to 4 times his potential exposure in cash markets. Now in such a situation, if his predictions for the stock goes wrong, his pay out will also increase by 4 times. However, if one is dealing in options, then the situation differs. If a person is speculating by buying an option, the pay out will be fixed, i.e. the call premium he pays. But if he is speculating by selling the options, in that case his payout becomes unlimited. Though the exchange keeps varying the margin money, but still one can easily speculate 3 to 4 times higher than his genuine cash market capacity.

    Allows higher exposure:
    Derivates definitely allow higher exposure in the sense, that at the same cash outgo, one can take higher exposure in the market. But derivative contracts being short-term, one has to keep rolling the contracts, in order to keep it live beyond three months. In Indian markets, the option contracts being European in nature, one can take advantage of profit booking opportunities. It can be helpful if one is taking position based on research. For e.g. if your fundamental research shows that valuations of stock A are attractive, but you don't have enough funds to buy stocks now, you can take exposure in derivative markets, which will provide you some time, within which you can arrange for funds and convert your position.

    Hedging:
    Hedging is the main purpose for which derivative contracts evolved. In early days, merchants used to lock in the prices that they will pay to farmers for the crop, that they would buy later. So in this kind of hedge, farmers are assured of a particular price that they would get, even if there is bumper crop (excess supply), and merchants are assured that they will buy crop at a particular price even if the crop is not good (supply shortage). In stock markets, derivatives contracts make sense basically for those who cannot invest for long term.

    Whatever the nature of objectives, as far as investors are concerned, derivative instruments are relatively risky in nature, mainly due to their short-term nature. Hence it is imperative that the investor understands derivative product thoroughly before investing in the same. The poll indicates that in the country these instruments are used more as speculative instruments rather than hedging tools. This in itself indicates the relatively risky nature of the Indian derivatives market. Research well before taking any decision, regarding investments, in these instruments.

     

     

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