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Equity Derivatives and Benefits of Equity Derivatives

Hey there! Welcome back again. Ever wondered what are Equity Derivatives? If yes, then this blog is a must-read.

Equity derivatives are financial products or instruments or a class of derivatives whose value is partly derived from an increase or decrease of one or more underlying equity securities or assets. Equity derivatives are usually used for hedging or speculation purposes, options and futures being the most common equity derivative products.

Equity derivatives are agreements between a buyer and a seller to either buy or sell at a predetermined price; they can either hold the right or the obligation to trade the asset at the expiry of the contract. To trade in an equity derivative, investors need to have very deep knowledge about the products and the industry. Investing in equity derivatives comes with a few risks such as interest rate risk, currency risk, and commodity price risk.

Five Main Types of Equity Derivatives

There are five main types of equity derivatives namely options, warrants, forwards and futures, convertible bonds, and swaps.

  1. Options:
    1. Options give the owner of equity derivatives the right & flexibility, but not the obligation, to buy (call option) or sell (put option) stocks at a given price traded over stock exchanges.
    2. The exposure in options is limited to the cost of the option as it is not obligatory to execute the contract on reaching maturity.
    3. The contract provides information about the given price, called the strike price, the expiry date, and the terms and conditions of the contract.
    4. Options contract perfectly suits investors who want to protect or hedge funds from an increase or decrease in prices in the future.
  2. Warrants:
    1. Like options, warrants give the holder the right, but not the obligation, to buy (call warrants) or sell (put warrants) the underlying investment on the future date and decided rate.
    2. Warrants are issued by companies for their bonds or preferred stock as an incentive to buy the issue.
  3. Forwards & Futures:
    1. Forwards are flexible obligatory private contracts specifying the predetermined date and price for buying or selling the underlying asset.
    2. Forward contracts mostly take place in the private market, where terms are tailored according to the parties involved in the contract.
    3. They are more flexible in terms of the underlying security, the quantity of security, and the date of transaction.
    4. Futures are standardized non-obligatory contracts where the buyer can buy or sell anytime as the prices are settled daily.
  4. Convertible bonds:
    1. Convertible bonds are a type of bond which gives the holder the option to convert the bonds into shares of the company.
    2. Along with other features of the bond (coupon and maturity date), one thing to be noted here is that the convertible bonds also come with a conversion rate and price associated with it.
    3. This is mostly because of the conversion feature wherein such types of bonds pay a comparatively lower rate of interest compared to the normal bonds.
  5. Swaps:
    1. Swaps are contracts that take place between two parties in exchange for the financial obligation in the derivative contracts.
    2. In other words, Swaps are contracts where returns of two different financial instrument/equity stocks are exchanged between two parties, or the exchange may also be related to floating/ fixed interest rates, or exchange of the currencies of different countries, etc.

What are the Benefits of Equity Derivatives

Let us now understand the benefits of Equity Derivatives:

  • The following are the benefits in equity derivatives trading:
    1. Hedging and Risk Management:
      • This mechanism can be used to reduce the risks of adverse price movements in stock prices.
    2. Leverage:
      • This mechanism allows to gain greater exposure by investing smaller amounts.
    3. Arbitrage:
      • This mechanism allows making profits by exploiting the mispricing of the same stock in both equity derivatives markets and the cash market.
    4. Liquidity:
      • This mechanism helps the continuous flow of information and transparency due to price discovery, thus enhancing liquidity.
    5. Low transaction costs:
      • In this mechanism, the transaction costs are low as trading is based on margin money.

The Various Types of Risks Associated with Derivatives

Let us also understand the various types of risks associated with Derivatives:

  1. Interest rate risk:
    1. An investor who expects the interest rates to rise in the future and enters a derivative contract to pay a fixed interest rate in the future can face a risk if interest rates go down.
    2. By agreeing to a fixed rate of interest, an investor would be locked into paying more money rather than taking a loan in the future at a lower rate.
  2. Currency risk:
    1. Importers and exporters enter derivative contracts to hedge fluctuating currency rates. The currency rates fluctuate often, and if it falls or goes up, it can create a monetary loss.
  3. Commodity price risk:
    1. Commodities are traded if investors expect the prices of the underlying asset to go down in the future.
    2. There are some commodities whose prices cannot be determined due to market volatility; the most common type of such commodity is the oil futures.
    3. If the price of the commodity goes up in the future, the investor can incur a monetary loss as an investor has to sell the commodity at the specified price which is lower compared to the future price.

If you wish to learn more about such topics, then the CFA course is the right career choice for you. The CFA course full form is Chartered Financial Analyst and is one of the most elite programs in the field of Finance. The CFA course duration would be a minimum of 2-3 years to complete all three levels. To know more about the CFA course details, please feel free to get in touch with our counsellors, who would be more than happy to assist you. All the best and happy learning.