How can Derivatives be used to Reduce Risk

Derivatives are financial instruments whose value is derived from the value of an underlying security or asset. This underlying asset can be a stock or commodity or any other similar asset. Derivatives are traded in the form of contracts where the buyer and seller enter a contract of buying or selling the underlying asset. Derivatives can be broadly classified in to two types:

· OTC derivatives: These types of derivative contracts are not standardized and are usually traded over the counter. Therefore, they often come with high risk of defaults. Examples of such contracts are Swap and Forward contracts.

· Standardized derivatives: These are the most widely traded form of derivative contracts. Since they are standardized, they are traded on the exchanges and have a very low default risk.

Derivatives are widely used by investors for hedging risks. Hedging is the strategy in which the investor creates a new position in a related security which helps in risk mitigation against opposite price movements.

Let us understand this with an example. Let us suppose an investor buys 100 shares of XYZ limited at the price of 50 Rs per share. The investor thinks that the stock will soon cross a level of 70 Rs per share and he will be able to book profit at that point. However, after 2 months when the stock was trading at the price of Rs 60 per share, the company incurred some losses which could affect the share price.

Now the worried investor can enter a put option contract to hedge his risk against any downfall in the price of the shares. With the put option the investor has the right to sell his shares of XYZ limited at a price fixed today in a future date. However, he is not obligated for the sale. So now if the shares prices fall, he can exercise the contract and protect himself from the loss and in case the stock prices don’t fall he can close the contract.