One of the main characteristics of share market is that is unexpected and volatile in nature. Prices of different currency keep on changing from time to time that results in expected losses for an investor. There is a method that can help an investor in reducing this uncertainty in share market called as hedging. One of the best methods of hedging is derivatives. Derivatives can be defined as the product whose value is determined with the help of an underlying product. Hence it can be said that value of a derivative is analysed and determined on the basis of characteristics and features of an underlying asset. The main objective of the use of derivative is to bring down the level of uncertainty that could result in financial loss for an investor.
Types of derivative instruments
There are different types of the derivative; four such derivatives that can be used to avoid another subprime mortgage financial meltdown are as follows-
The most common type of derivative instrument that is used to avoid a loss on foreign currency transaction is a forward contract. This forward contract is very common which involve two parties that are buyer and seller of the contract. Both of these parties agree to the sale and purchase foreign currency at a future time and at a specific rate. The share price prevailing at the date of execution of the contract is irrelevant for both of these parties (Somanathan, Nageswaran & Gupta, 2017). There will be one party either seller or buyer that has to incur a loss in this transaction but through this contract both of these parties has prevented themselves from the fluctuation of share market. There is usually no right of cancellation to both of these parties.
Future contracts are considered as the evolved forward contract. The basic concept of future contract is similar to the forward contract as this contract also involves two parties that have agreed to sell or purchase a certain commodity or share at certain price and date in future. The main difference in case of the forward contract is that it is regulated in public domain (Beneda, 2013). These contracts are regulated by the prices decided in a separate market that is called as a future market. In addition to that, another important difference is that the settlement in this contract is done on daily basis (Battiston, Caldarelli, Georg, May & Stiglitz, 2013). Every day, the party that has incurred a loss in this contract is required to pay to the profit-making party.
There are two types of option that are available in an option contract that are call and put. A call option gives a right to the buyer of a contract to exercise right to purchase on or before a specific date and specific rate. There is no obligation on part of the buyer to buy. Hence if the share price is higher than the buyer will exercise its right otherwise he will not exercise its right. Same as in case of a put option with the right to sell is given to the buyer in the contract. Such buyer will buy if the price of share or commodity is lower than contracted price (Ryan, 2012).
A swap is a derivative contract in which two parties to contract decide to swap cash flow that will be generated in future. There can be types of swaps i.e. interest rate swap and currency swap. In interest rate swap only interest earned in cash =flows are exchanged whereas in case of currency swaps both interest and the principal amount of cash flow is exchanged. This swap contract is not limited to cash flows can swap can be done for any financial instrument as per the contract between seller and buyer.
Use of derivatives in the financial market has been increasing at a constant rate and it has become more formalized and organized over the period of time. These are considered as very useful measures to deal with the risk and uncertainty generated by financial market and helps in protection of investor’s interest (Hull & Basu, 2016). The use of derivative market has especially increased after the subprime mortgage financial meltdown which resulted in the collapse of real estate market. But the major problem with this market is that investor does not have complete knowledge of regarding derivative instruments and manner in which investment should be done in the derivative market to manage risk. In past, there have been various cases where investors have to incur huge losses like in case of a global crisis in 2007 (Lo, 2012). The use of derivative instruments is expected to increase in future as investors are understating its advantages and manner in which it is helping to manage their risk.
Battiston, S., Caldarelli, G., Georg, C. P., May, R., & Stiglitz, J. (2013). Complex derivatives. Nature Physics, 9(3), 123.
Beneda, N. (2013). The impact of hedging with derivative instruments on reported earnings volatility. Applied Financial Economics, 23(2), 165-179.
Hull, J. C., & Basu, S. (2016). Options, futures, and other derivatives. Pearson Education India.
Lo, A. W. (2012). Reading about the financial crisis: A twenty-one-book review. Journal of economic literature, 50(1), 151-78.
Ryan, S. G. (2012). Financial reporting for financial instruments. Foundations and Trends® in Accounting, 6(3–4), 187-354.
Somanathan, T. V., Nageswaran, V. A., & Gupta, H. (2017). Derivatives. Cambridge Books.