What are derivatives?
Derivatives are financial instruments, which as the name suggests, derive their value from another asset — called the underlying.
What are the typical underlying assets?
Any asset, whose price is dynamic, probably has a derivative contract today. The most popular ones being stocks, indices, precious metals, commodities, agro products, currencies, etc.
Why were they invented?
In an increasingly dynamic world, prices of virtually all assets keep changing, thereby exposing participants to price risks. Hence, derivatives were invented to negate these price fluctuations.
For example, a wheat farmer expects to sell his crop at the current price of Rs 10/kg and make profits of Rs 2/kg. But, by the time his crop is ready, the price of wheat may have gone down to Rs 5/kg, making him sell his crop at a loss of Rs 3/kg. In order to avoid this, he may enter into a forward contract, agreeing to sell wheat at Rs 10/ kg, right at the outset.
So, even if the price of wheat falls to Re 1/kg or rises to Rs 20/kg, he is able to sell it at Rs 10, thereby staying immune to any price change.
How do losses occur?
Let us take a scenario, where he has agreed to sell wheat at Rs 10/kg, without being sure of the quantity he will be able to produce in the future, i.e., without having an exposure to the underlying. So, if the price of wheat rises to Rs 20/ kg, he is forced to sell wheat at Rs 10/kg, thereby making a loss of Rs 10/kg.
What is mark to market (MTM)?
The daily inflow or outflow of cash as a result of a favorable or unfavorable movement in the price of the contract, until the whole contract is terminated, is known as mark to market. So, considering our above example, if at a certain point in time, wheat is trading at Rs 15/kg, then our farmer is said to be sitting on a markto-market loss of Rs 5/kg.
Can mark-to-market losses increase?
Of course they can. If the price of wheat in our example keeps rising, then the farmer’s mark-to-market losses keep increasing until he terminates the contract and books his losses.
What do Indian laws say?
Indian laws allow companies to get into the forex derivative market only when there is a genuine underlying exposure. But with the huge temptation of massive profits arising out of a favorable movement in prices, many Indian companies have taken or have been lured into taking naked speculative punts by their banks.
For example, an Indian exporter expecting to be paid in dollars is allowed to take positions in the forex market to hedge against an appreciation in the rupee.
But the exporter has no business taking a USD-GBP speculative bet (whether the exporter is expecting the dollar to appreciate or depreciate against the British pound is irrelevant) when it has no exposure to any asset that is affected by a fluctuation in the USD-GBP forex rate.
Why do they seem to be so notorious?
Because of the high leverage that derivatives offer, they are double-edged swords, i.e., although profits get magnified, so do losses. And at times, because of the high leverage, the losses incurred by an investor are more than even the entire invested capital. This is probably why legendary investor Warren Buffett has been quoted as saying, ‘’derivatives are financial weapons of mass destruction’’.
Derivatives are financial instruments, which as the name suggests, derive their value from another asset — called the underlying.
What are the typical underlying assets?
Any asset, whose price is dynamic, probably has a derivative contract today. The most popular ones being stocks, indices, precious metals, commodities, agro products, currencies, etc.
Why were they invented?
In an increasingly dynamic world, prices of virtually all assets keep changing, thereby exposing participants to price risks. Hence, derivatives were invented to negate these price fluctuations.
For example, a wheat farmer expects to sell his crop at the current price of Rs 10/kg and make profits of Rs 2/kg. But, by the time his crop is ready, the price of wheat may have gone down to Rs 5/kg, making him sell his crop at a loss of Rs 3/kg. In order to avoid this, he may enter into a forward contract, agreeing to sell wheat at Rs 10/ kg, right at the outset.
So, even if the price of wheat falls to Re 1/kg or rises to Rs 20/kg, he is able to sell it at Rs 10, thereby staying immune to any price change.
How do losses occur?
Let us take a scenario, where he has agreed to sell wheat at Rs 10/kg, without being sure of the quantity he will be able to produce in the future, i.e., without having an exposure to the underlying. So, if the price of wheat rises to Rs 20/ kg, he is forced to sell wheat at Rs 10/kg, thereby making a loss of Rs 10/kg.
What is mark to market (MTM)?
The daily inflow or outflow of cash as a result of a favorable or unfavorable movement in the price of the contract, until the whole contract is terminated, is known as mark to market. So, considering our above example, if at a certain point in time, wheat is trading at Rs 15/kg, then our farmer is said to be sitting on a markto-market loss of Rs 5/kg.
Can mark-to-market losses increase?
Of course they can. If the price of wheat in our example keeps rising, then the farmer’s mark-to-market losses keep increasing until he terminates the contract and books his losses.
What do Indian laws say?
Indian laws allow companies to get into the forex derivative market only when there is a genuine underlying exposure. But with the huge temptation of massive profits arising out of a favorable movement in prices, many Indian companies have taken or have been lured into taking naked speculative punts by their banks.
For example, an Indian exporter expecting to be paid in dollars is allowed to take positions in the forex market to hedge against an appreciation in the rupee.
But the exporter has no business taking a USD-GBP speculative bet (whether the exporter is expecting the dollar to appreciate or depreciate against the British pound is irrelevant) when it has no exposure to any asset that is affected by a fluctuation in the USD-GBP forex rate.
Why do they seem to be so notorious?
Because of the high leverage that derivatives offer, they are double-edged swords, i.e., although profits get magnified, so do losses. And at times, because of the high leverage, the losses incurred by an investor are more than even the entire invested capital. This is probably why legendary investor Warren Buffett has been quoted as saying, ‘’derivatives are financial weapons of mass destruction’’.
