Question

Derivatives can be used for the specific investment objectives of speculating or hedge? Discuss these objectives how they can be of value in portfolio management.

Answer 1

Derivatives are instruments that derive their value from the under lying asset. For instance equity derivative derive their value from equity. There are two broad types of derivates: Over the counter and Exchange traded. Over-the-counter derivatives are those instruments that are created and customized by the parties involved. Exchange-traded derivatives are those instruments that are traded in a stock exchange. The most common types of derivatives are futures, forwards, options and swaps. There are several types of underlying securities - equity, fixed income, commodities, market indices, currency exchange rates, etc. Because of such a huge variety of underlying securities, investment in derivatives can provide exposure to a wide range of asset classes. It is cheaper to invest in derivatives than in physical underlying securities. Investment in derivatives works on the principle of leverage - i.e., investors can take large exposure to derivatives by investing only a fraction of the amount. In portfolio management derivatives can be used for speculation as well as hedging. Speculation arises when the portfolio manager bets on the price movements of the assets/ derivative instruments included in his diversified portfolio. By speculation the portfolio manager is able to take calculated risk to earn profit. If they want to rebalance their portfolio i.e. Wanting to reduce the proportion of equities in portfolio and to increase bond then they can Sell Stock Index Futures and buy bond futures. Hedging is used by portfolio managers to eliminate the risk in their portfolio. The risk is basically the future price movements in the assets in their portfolio. Portfolio managers can hedge their position in the spot market by taking the opposite position in the derivatives market. This will protect them from any volatility in the prices of the underlying asset that is included in their portfolio.