Derivatives are financial instruments that have values derived from other assets like stocks, bonds, or foreign exchange. Derivatives are sometimes used to hedge a position (protecting against the risk of an adverse move in an asset) or to speculate on future moves in the underlying instrument. Hedging is a form of risk management that is common in the stock market, where investors use derivatives to protect shares or even entire portfolios.
Key Takeaways
- Derivatives are financial instruments that have values tied to other assets like stocks, bonds, or futures.
- Hedging is a type of investment strategy intended to protect a position from losses.
- A put option is an example of a derivative that is often used to hedge or protect an investment.
- Buying or owning stock and buying a put option is a strategy called the protective put.
- Investors can protect gains of a stock that has increased in value by purchasing a put.
What Are Derivatives?
A derivative is a financial instrument with a price that depends on (or is derived from) another asset. It is typically a contractual agreement between two parties in which one party is obligated to buy or sell the underlying security and the other has the right to buy or sell the underlying security.
However, derivatives can take many forms and some—like OTC derivatives—are complex and mostly traded by professional rather than individual investors. On the other hand, many derivatives are listed on derivatives exchanges and are standardized in terms of the quantities traded (size), expiration dates, and exercise (strike) prices.
Equity options are examples of derivative contracts. A call option gives the owner the right (not the obligation) to buy 100 shares of stock per contract. A put option, on the other hand, is a contract that gives the holder the right to sell 100 shares of stock. Put options are often used to protect stock holdings or portfolios.
Example of Hedging
Hedging is the act of taking a position in a related and uncorrelated security, which helps to mitigate against opposite price movements. For example, assume an investor bought 1,000 shares of Tesla Motors (TSLA) for $65 a share. The investment is held for over two years and now the investor is worried that Tesla will miss earnings per share (EPS) and revenueexpectations—sending shares lower and giving back some of the profits accumulated over those two years.
In April 2019, Tesla's stock price was $239—representing a value of $239,000 and an unrealized profit of $174,000 on 1,000 shares—and the investor wants to initiate a protective strategy. To hedge the position against the risk of any adverse price fluctuations, the investor buys 10 put option contracts on Tesla with a strike price of $230 and a September expiration date.
The Multiplier Equals 100
Options are quoted in dollars and cents, like stock, but the dollar value that the investor pays is 100 times the quote (premium) because of the multiplier—So if the put costs $10 per contract, the investor pays $1000 per contract, which is equal to the $10 premium times the multiplier (100).
The put option contract gives the investor the right to sell his shares of Tesla for $230 a share through September. Since one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100 x 10) shares with 10 put options. This strategy—of buying shares and buying puts—is called the protective put.
Exercising Options
If Tesla misses its earnings expectations and the stock price falls below the $230 strike price, the investor has locked in a selling price of $230, through September, with the put option. The investor can sell the put after any increase in value or exercise the put: selling 1,000 shares at $230, gaining a profit of $165 ($230 - $65) per share. Once the put option is exercised (and a seller of the put has been assigned at $230 per share), the contract ceases to exist.
A holder of a put option is under no obligation to exercise the contract and it is often better to sell the put rather than to exercise it, but the seller (the other side of the options contract) of a put option has an obligation to take delivery of the stock if assigned on the put.
Of course, the put option was not free and the investor paid a premium to buy the protection. The premium paid reduces the net profits from exercising the contract. In the example, if each put costs $10, the net profit is $155 rather than $165 per share. On the other hand, if shares stay above $230 through the September expiration, the put will be worthless and the entire premium paid is lost, which is $10,000 on 10 contracts. Until then, the value of the put will change as time passes, and as the price of Tesla moves higher and lower.
FAQs
When used properly, derivatives can be used by firms to help mitigate various financial risk exposures that they may be exposed to. Three common ways of using derivatives for hedging include foreign exchange risks, interest rate risk, and commodity or product input price risks.
How should derivatives be used in risk management? ›
One of the most common uses of derivatives in risk management is to hedge against interest rate risk. This can be done by using interest rate swaps, which allow investors to exchange a fixed rate of interest for a floating rate of interest.
How can derivatives be used to reduce risk can derivatives be used to increase risk explain? ›
Derivatives are very instrumental in managing the risk , using derivatives an investor can be able to reduce risk by locking in a price using forwards and futures for a future transaction thereby reducing the uncertainty.
How do companies use derivatives to hedge risk? ›
Although companies cannot control these global crises, they can shield themselves from many unpredictable risks using derivatives. Derivatives are financial tools that allow businesses to set fixed prices, protect against currency fluctuations, and guard against interest rate changes.
How do banks use financial derivatives to mitigate risk? ›
Banks use derivatives to buy protection
For example, a bank's financial profile might make it vulnerable to losses from changes in interest rates. The bank could purchase interest rate futures to protect itself. Or, a pension fund can protect itself against credit default.
What are the main benefits and risks of derivatives? ›
Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares. The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks.
What are the three main reasons for the usage of derivatives? ›
Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement.
Can derivatives increase risk? ›
For less experienced investors, however, derivatives can have the opposite effect, making their investment portfolios much riskier.
What do derivatives play a key role in transferring risks in the economy? ›
By allowing investors to unbundle and transfer these risks, derivatives contribute to a more efficient allocation of capital, facilitate cross-border capital flows, and create more opportunities for portfolio diversification. Thus, financial derivatives are essential for the development of efficient capital markets.
What is risk management for equity derivatives? ›
Risk Management for Derivative products is managed with Standard Portfolio Analysis of Risk (SPAN)®is a highly sophisticated, value-at-risk methodology that calculates performance bond/margin requirements by analyzing the "what-if's" of virtually any market scenario.
One of the key benefits of financial derivatives is their ability to assist in risk management and protect investments. Derivatives, such as options and futures, allow investors to hedge against potential losses.
What is the difference between a hedge and a derivative? ›
Hedging is an investment technique or strategy. Derivatives are investment instruments—a type of asset class. The two are related, though, in that hedging strategies—which aim to insure against overall loss—often use certain kinds of derivatives, especially options and futures contracts.
Why do hedge funds use derivatives? ›
Derivative Trading
A financial derivative is a contract derived from the price of an underlying security. Futures, options, and swaps are all examples of derivatives. Hedge funds invest in derivatives because they offer asymmetric risk.
How derivative is useful in risk management? ›
Derivatives are financial instruments that have values derived from other assets like stocks, bonds, or foreign exchange. Derivatives are sometimes used to hedge a position (protecting against the risk of an adverse move in an asset) or to speculate on future moves in the underlying instrument.
How do financial derivatives reduce risk? ›
A derivative can both reduce risk, by providing insurance (which, in financial parlance, is referred to as hedging), and magnify risk, by speculating on future events. Derivatives provide unique and different ways of investing and managing wealth that ordinary securities do not.
What is the use of credit derivatives for risk management? ›
A bank can use a credit derivative to transfer some or all of the credit risk of a loan to another party or to take additional risks. In principle, credit derivatives are tools that enable banks to manage their portfolio of credit risks more efficiently.
Which of the following risks would be managed through the use of derivatives? ›
Businesses and investors use derivatives to increase or decrease exposure to four common types of risk: commodity risk, stock market risk, interest rate risk, and credit risk (or default risk).
How are derivatives used in fund management? ›
They can be used to reduce risk, provide downside protection and enhance efficient portfolio management. They can also help to dampen a fund's volatility, as well as to take directional views – for example to allow managers to short an asset – adds Neilson.
