Why do we need derivatives?

Derivatives are needed for the economy to serve three functions. These three functions are necessary for the proper functioning of the economy.

• Price discovery

• Risk management

• Speculative activity

PRICE DISCOVERY

Derivatives are a dominant factor for discovering the price of a commodity or financial asset. It is an integral component of an economic system that is efficient. Stocks and commodities prices tend to move up or down, as expected by the market participants. The futures market price reveals the expectation of demand and supply in the future. It leads to the discovery of the spot price.

Let us take the example of someone manufacturing sugar. This person does not know what would be the price of sugar after two months. But by watching the futures market price of sugar, he can figure out the requirement of sugar after two months and finalize the production plan.

Let look at another scenario. We have two jewelers, one in Mumbai and the other in Delhi, and the price of gold may be slightly different in Mumbai and Delhi. Derivative contracts of gold on the NSE have only one value. Based on this, traders in Mumbai and Delhi can fix the prices of spot markets in their locality and decide a profitable price.

Managing Risk.

Whether you an individual or an organization, you are prone to unexpected losses due to uncertainties. You can use these derivatives as a device to manage the risks due to price fluctuations.

Let us say that you are holding Reliance shares trading at Rs.2000. Your view is that the price is likely to come down to Rs 1800. As reliance futures are available at Rs.2300, you can sell the shares for Rs.2300 and fix your profit. If the price were to go down to Rs. 1800 as expected by you, you would have ended up with a loss of Rs. 200 a share.

It is called Hedging. It is a process that involves making a new investment to offset an expected loss in an existing one.

In another example, let us say the Reliance shares are trading at 1800. You buy Reliance options at 1800 strike price. It gives you the right to purchase Reliance shares at Rs.1800. You will never exercise the right at the end of the month if the share price was to go below Rs.1800 or remain the same. You would lose the premium you paid for the option.

The amount paid as premium will be your maximum loss. On the other hand, the price was to go above Rs.1800 to Rs. 2000, then you will exercise your right to buy at Rs.1800. You will purchase the shares at Rs. 1800 and sell them at Rs.2000 and making a profit Rs.200, less the amount of premium paid.

The profit you can make is unlimited. Let us assume that you paid a premium of Rs.20, and the lot size is 500. Instead of Rs.2000, if the price had gone up to Rs.2500, then the profit would be Rs.700 a share. The total profit would be Rs.3,40,000 (Rs.700*500 = Rs.3,50,000 less 20*500 =10,000)

Derivatives, therefore, help investors who are informed to make use of price movements to their advantage.

Speculation

The volume of trading activity by speculators causes fluctuations in the movement of price. The price movement is due to market sentiments and has nothing to do with the fundamentals of the share. Speculators look for stocks that are over-priced or under-priced. For example, if the speculator feels that price of a particular stock is high and is likely to go down, he would sell the stock. Other investors will follow this trend, and the large volume of sales will bring the price to its actual value. Speculators facilitate liquidity to shares and help in maintaining the balance.