WHAT IS DERIVATIVE TRADING AND HEDGING

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SANJAY JAIN

SANJAY JAIN (Querist)
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04 December 2009 What is derivative trading and how it operates. And what is hedging and where it is used.

CS Mitesh Mehta

CS Mitesh Mehta (Expert)
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05 December 2009 Derivatives are specialised contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.

The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset.
Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customised as per the needs of the user by negotiating with the other party involved.

However, exchange traded derivatives have some advantages like low transaction costs and no risk of default by the other party, which may exceed the cost associated with leaving a part of the production uncovered.

Some of the most basic forms of Derivatives are Futures, Forwards and Options.

Futures and Forwards

As the name suggests, futures are derivative contracts that give the holder the opportunity to buy or sell the underlying at a pre-specified price some time in the future.

They come in standardized form with fixed expiry time, contract size and price. Forwards are similar contracts but customisable in terms of contract size, expiry date and price, as per the needs of the user.

Options

Option contracts give the holder the option to buy or sell the underlying at a pre-specified price some time in the future. An option to buy the underlying is known as a Call Option.

On the other hand, an option to sell the underlying at a specified price in the future is known as Put Option.

In the case of an option contract, the buyer of the contract is not obligated to exercise the option contract. Options can be traded on the stock exchange or on the OTC market.

The Derivatives Trading at BSE takes place through a fully automated screen based trading platform called as DTSS (Derivatives Trading and Settlement System). The DTSS is designed to allow trading on a real time basis. In addition to generating trades by matching opposite orders, the DTSS also generates various reports for the member participants.

Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.

How hedging is done

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.

The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. It needs to be noted that hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return.