In developed countries, the financial derivative markets play a major role. In such a market it is the financial derivatives which are traded among the parties and under this article I am going to discuss about the ways of using such financial derivatives. A financial derivative is a financial instrument whose value depends on the value of other basic underlying variables on which it is written.
Eg:
- forward contracts
- Futures contracts
- Put options
- Call options
- Swaps are some of the examples for such financial derivatives.
These derivatives can be used in many ways.
1. To hedge the risk
In a derivative market, there are mainly three types of players. They are hedgers, speculators and the arbitrageurs.
Hedger is one who tries to offset investment risk by buying and selling derivatives.
So the hedgers will use financial derivatives in order for them to hedge the risk and when hedging risks they assume that the environment is uncertain and it cannot be predicted well in advance. So when a hedger wants to mitigate the risk or in other words if he wants to control the volatility of a transaction he would go for a financial derivative.
Eg : A company will pay $12 Million for imports from the USA in 4 months and they decide to hedge using a long position in a forward contract.
In the above example, the future in 4 months is uncertain. The exchange rate would either be depreciated or appreciated. If in case it got depreciated in future then this company will have to pay more than what they agreed at the beginning. So in order to mitigate that risk, they can hedge the risk with the help of financial derivatives.
2. To speculate
Speculators are again one of the main key players in a financial derivative market and a speculator is one who tries to profit from buying and selling derivatives by anticipating the future price movements.
When the speculators use such financial derivatives they usually hold the assumption that the environment can be predicted. Before holding the positions they try to predict the environment and then only they come to a decision as to whether they should go for a long position or for a short position.
These speculators are the ones who take risks while the hedgers end up controlling the risks.
Therefore the financial derivatives can be used to speculate too.
Eg: An investor who possesses $4000 feels like Amazon.com’s stock price will go up over the next two months. The current stock price is $40 and the price of a two-month call option with a strike of 45 is $2.
The followings are the alternative strategies that the investor can take in this example.
2.1 Conventional investment strategy
(buying a stock)
Assumption- the price of a share at the end of 2 months is assumed to go up to $60.
- amount of the money available to invest = $4000
- Price of a share = $40
- Therefore the maximum number of shares that he can purchase right now
= 4000/40
= 100 shares
- Market value of all the shares at the end of the 2 months period = 60*100
= $6000
Cost of the investment = $(4000)
Therefore the gain = $2000
2.2 With the use of financial derivative strategy
Assumption- the price of a share is assumed to go up to $60 at the end of the 2 months period.
- The amount of the money available to invest = $4000
- Price of an option = $2
- Therefore the number of options that the investor can buy
= 4000/2
= 2000 options
- Price per share
(at the end of the period )= $60
Strike price of the option = ($45)
Gain per option = $15
Therefore the total gain = Gain per option*total number of options
= $15*2000 options
= $30000
3. To lock in an arbitrage profit
An arbitrageur is one who tries to profit when the same asset is traded at different prices in two or more markets. They seek for the mispriced securities so that they can earn a profit.
So the financial derivatives are used by such arbitrageurs in order for them to make profits.
Usually, the arbitrageurs will look for opportunities where they can earn a return for more than risk-free rate while undertaking zero risks.
Eg : If an asset is overpriced seller gets the arbitrage opportunity whereas the asset is under-priced buyer gets the arbitrage opportunity.
So when using the financial derivatives by such arbitrageurs they try to lock in an arbitrage profit and that is how they use financial derivative when arriving at their objectives.
4. To change the nature of a liability and to change the nature of an investment
Financial derivatives can be used to change the nature of both the liabilities and the investments.
In the derivative market, there are lots of financial derivative tools such as forwards, futures, options and Swaps etc. even though there are a number of derivative tools, most of the time it is the Swap agreements which will be useful when changing the nature of the liabilities and the investments.
So let’s see what is a Swap agreement.
The swap agreement is an agreement to exchange cash flows at specified future times according to certain specified rules.
There are mainly two types of Swap agreements and they are as follows.
- Interest rate Swap
- Exchange rate Swap
Eg : An agreement by company A to receive 3 month LIBOR and pay a fixed rate of 5% per annum every 3 months for 3 years on a notional principal of $100 million.
*Here the 100 Million is not exchanged between the parties and the interest is paid for this amount. This 100 million is known as the notional principal.
Conclusion
- Financial derivatives has many uses and we can use them in many ways when achieving our objectives.
- If you are a hedger u will use such financial derivatives to mitigate risks while a speculator would use a derivative to make a profit while taking risks.
- At the same time to speculate and to change the nature of the liabilities and the investments, these can be used too.
- But when using them you need to make sure that you have a thorough understanding about both the market and the tools. Otherwise, you will end up earning losses.