Derivatives play a very crucial role in risk management, speculation, and portfolio diversification. Derivatives draw value from an underlying asset like stocks, commodities, interest rates, or currencies. Among the many forms of derivatives, Futures, Options, and Swaps are the most common. If you’ve ever wondered how these financial tools work and how they can benefit investors and businesses, you’re in the right place.
Futures: Locking in a Price for Tomorrow
Example:
Suppose you are a wheat farmer concerned about fluctuating prices. Wheat today costs ₹2,000 per quintal, and you apprehend that by the time your crop is ready to be sold, the price will be lower. You can go into a futures contract selling wheat at ₹2,000 per quintal three months later. You will thus be protected from the decline in price even if the market price of wheat has come down to ₹1,800. On the other hand, if prices rise to ₹2,200, you’ll still sell at ₹2,000, as per your contract.
Futures work well for businesses and investors who want to manage price risks. These contracts are traded on exchanges, making them transparent and standardised.
Options: The Right, but Not the Obligation
Unlike futures, an option provides you with the right to buy or sell a specific asset at a fixed price before a specified date, but you are not obligated. There are two types of options: Call Options for buying and Put Options for selling. They are widely used in speculation and hedging.
Example:
You are considering buying shares of a company that is trading at ₹500 per share. You believe that the price may rise, but you want to keep the risk to a minimum. You can buy a call option at a strike price of ₹520 for a premium of ₹10. At a stock price of ₹550, you can exercise your option, buy at ₹520, and make some money. However, if the price remains below ₹520, you can allow the option to lapse, and your loss will be just the ₹10 premium.This flexibility makes options popular among investors seeking limited risk but with the potential for high returns.
This flexibility makes options popular among investors seeking limited risk but with the potential for high returns.
Swaps: Exchange Cash Flow
Swaps are derivatives whereby two parties agree to trade off financial obligations, mostly involving interest rates or currencies. It is mostly used by huge companies or financial houses for risk management.
Example:
Consider a firm that has received a loan at a floating interest rate but wants the rate to be fixed for smooth financial planning. The company can enter into an agreement to swap interest with another party who prefers the floating rate. For example, one party pays a fixed rate and the other a floating rate. This reduces the risk both parties face during financial planning.
The currency swaps also work similarly, whereby the parties exchange principal and interest payments in different currencies to hedge against exchange rate fluctuations.
Key Differences Between Futures, Options, and Swaps
| Futures |
Options |
Swaps |
| Obligation |
| Both parties are obligated to trade |
Buyer has the right, not the obligation |
Both parties are obligated to exchange |
| Market |
| Traded on exchanges |
Traded on exchanges and over the counter |
Traded over the counter |
| Purpose |
| Hedging and speculation |
Hedging, speculation, and income generation |
Risk management |
Why Should You Know About Derivatives?
Derivatives can be powerful tools for managing financial risks for both individual investors and businesses. If you want to hedge against price fluctuations, generate additional income, or speculate on market movements, these instruments provide the flexibility and leverage you need.
For instance, if you are an exporter, currency swaps can protect you against adverse movements in the exchange rate. As an investor, options enable you to benefit from market opportunities without putting much capital at risk.
However, like any investment products the investor need to have a complete understanding. Though in explanation these types of derivatives sound very simple but the speculation in these need to be practical and backed by right research. The knowledge on the subject can truly help you minimise risks.
As we always advise, start with small investments, consult with experts, and educate yourself on how these instruments work. With time and experience, you’ll be better equipped to harness the potential of derivatives to meet your financial goals.