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Introduction to Derivatives

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Derivatives are financial instruments used to manage a person's exposure to volatile markets.

Derivatives are financial instruments used to manage a person's exposure to volatile markets. A derivative product's value depends upon and is derived from an underlying instrument, such as commodities, interest rates, indices or stocks.

In other words, a derivative is a financial contract with a value linked to the expected future price movements of the underlying asset it is linked to. Derivatives are used as a tool for hedging, speculating and arbitraging.

 

Futures and options are essentially elementary derivative products mostly traded on exchanges. A futures contract is an agreement between two parties to buy or sell the underlying instrument at a specific time in the future at a specific price determined today.

An option however, provides the holder/buyer the right, but not the obligation, to purchase or sell a certain quantity of the underlying instrument at a stipulated price within a specific time period by paying a premium.

 

Type of Derivatives Available in Bursa Malaysia

Exchange-Traded (ETD)

Contracts that are traded on derivatives exchanges.

Contracts traded are standardized as defined by the exchange.

Derivatives exchange acts as a counter-party to all contracts.

Over-the-Counter (OTC)

Contracts that are privately negotiated and traded directly between two parties.

The OTC market is the largest market for derivatives.

 

Is Investing in Derivatives Right for You?

Are you a…?

Description

Advantage or Disadvantage?

Additional Information

Risk Level

HEDGER

Individuals and firms who trade in the futures market purely to establish a known price level in advance. The reason for this is so that they can later buy or sell the derivative in the cash market.

They protect themselves against the risk of an unfavourable price change in the interim.

May also use futures to lock in an acceptable margin between their purchase cost and their selling price.

Investors use this strategy when they are unsure of what the market will do. Hence, a perfect hedge reduces your risk to nothing (except for the cost of the hedge).

SPECULATOR

Uses derivatives to acquire risk. Trades with a higher-than-average risk in return for a higher-than-average potential profit.

Does not promise safety of the initial investment, along with the return on the principal sum.

Is important because he takes on the risk which is unwanted by the hedgers.

 

Takes on large risk, especially when anticipating future price movements to make quick, large gains.

MARKET MAKER

Is a company or individual that quotes both a buy and sell price for a financial instrument, hoping to make a profit on the bid-offer spread*.

 

*spread: the difference between the ask and the buy price.

 

Market makers must be compensated for the risk they take; this is why spread comes into play.

The market maker at the stock exchange takes on the risk of filling an order with his or her own company's money.

 

ARBITRAGEUR

 

 

Attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capture risk-free profits

 

 

 

In theory true arbitrage is riskless, however, the world in which we operate offers very few of these opportunities. Despite these forms of arbitrage being somewhat risky, they are still relatively low-risk trading strategies which money managers (mainly hedge fund managers) and retail investors alike can employ.

 

© Securities Commission Malaysia (SC). Considerable care has been taken to ensure that the information contained here is accurate at the date of publication. However no representation or warranty, express or implied, is made to its accuracy or completeness. The SC therefore accepts no liability for any loss arising, whether direct or indirect, caused by the use of any part of the information provided. The information provided is for educational purposes only and should not be regarded as an offer or a solicitation of an offer for investment or used as a substitute for legal or other professional advice. For enquiries regarding sharing, republishing or redistributing this content please write to: [email protected].

Managing Equity Market Risk by Using Derivatives

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Experts have always advised investors to reduce risk in their investment portfolio by diversifying. However, even the most diversified portfolio fluctuates according to market movement. In this article, we take a closer look at managing equity market risks with the use of derivatives. By the end of this article, you as an investor will be able to identify:

  • the two basic risks inherent in an investment portfolio; and
  • how futures, as a form of derivatives, is used to manage market risks and turn one’s investment profile from equity to risk-free bond.

 

What is Equity Market Risk?

In the equity market, risk basically means the unpredictability of the expected return and how it affects the investment portfolio. There are two basic risks inherent in an investment portfolio: unsystematic risk or firm-specific risk (diversifiable) and systematic risk or market risk (non-diversifiable). When a portfolio is diversified, it basically means the firm-specific or asset-specific risk arising due to specific characteristics of the firm is removed. But of course, market risk, which is inherent in the portfolio, can never be fully eliminated because it is caused by the overall stock market and economic situation.

                  

Risk: Good or Bad?

Many investors wrongly perceive risk as bad for their portfolios. Yet at the same time, it is widely understood by investors that risk and return go hand in hand. In order to earn higher returns, we must assume higher risks. So, if we eliminate all risk, we will only earn risk-free returns, which is equivalent to risk-free rates. What all investors ultimately want is to preserve or enhance upside risk while minimising or eliminating downside risk.

 

Many investors also think that derivatives are financial instruments that are highly risky. They do not relish the idea of using derivatives to manage portfolio market risk. In actual fact, the development of financial derivatives instruments provides new ways of managing risk for investors!

 

Taking Advantage of Futures to Hedge Market Risk   

Futures are standard contracts being traded on the exchange. They are one of the most common derivatives used to manage equity market risk. Since most futures are based on broad indices, they can be used to manage the risk related to the indices that the futures are based on.

For example, if an investor is optimistic that the overall economy is heading towards recovery, but his current stock holdings are not big or diverse enough to resemble market exposure[1], he can consider buying futures contracts that are based on the broad market index. By doing this, when the market goes up, he will gain higher profits than his original portfolio. However, in the event that the market heads downwards, his losses will also be more than what he would lose in his original portfolio.

 

Now, assume an investor is currently holding a well-diversified portfolio, and based on his own observation, thinks the market may be heading downward. Instead of selling his current stock holdings, he can choose to hedge his portfolio by selling futures contracts. The amount of contracts to sell will depend on how much market risk the investor would like to hedge[2]. When the market actually drops, the investor will close his positions in the futures contracts and the profits earned can then be used to offset the drop in the value of his investment portfolio. However, if the market goes up, the losses in the futures contracts will also offset the increase in the value of this portfolio. By using futures to hedge his portfolio risk, he gets downside protection but at the same time foregoes upside potential.

 

In extreme cases, if the investor is very pessimistic about market conditions, he may choose to fully hedge his portfolio by selling the amount of futures contracts that is equivalent to the value of his investment portfolio. Effectively, the investor would be turning his investment profile from equity into a risk-free bond[3]:

 

 

Conclusion

 

Futures enable investors to change their risk and return profiles without changing their investment holdings. This is very important as oftentimes, ups and downs in the market are only temporary. If investors were to change their investment holdings to get broader market exposure, they would need more capital and incur a lot more transaction costs compared to using futures. Additionally, to change the stock holdings would mean investors need to do in-depth research before deciding what to sell or buy.

 

Ultimately, using futures to manage equity market risk gives the flexibility of altering your equity market risk profile without changing your stock holdings, making it a very viable market risk management solution for any investor.

 



[1] The exposure of a portfolio to particular securities/markets/sectors must be considered when determining asset allocation since it can greatly increase returns or, if properly done, minimise losses. For example, a portfolio with both stocks and bonds holdings will typically have less risk than a portfolio with exposure only to stocks.

 

 

[2] To make an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

 

 

[3] An example of a risk-free bond is the 10-year Malaysian Government securities (MGS) issued by the Government of Malaysia. In theory, these bonds are relatively risk-free and not at risk of bankruptcy.

 

© Securities Commission Malaysia (SC). Considerable care has been taken to ensure that the information contained here is accurate at the date of publication. However no representation or warranty, express or implied, is made to its accuracy or completeness. The SC therefore accepts no liability for any loss arising, whether direct or indirect, caused by the use of any part of the information provided. The information provided is for educational purposes only and should not be regarded as an offer or a solicitation of an offer for investment or used as a substitute for legal or other professional advice. For enquiries regarding sharing, republishing or redistributing this content please write to: [email protected].