Learning Derivatives: Hedgers, Speculators, Arbitrageurs

As we understood in the last article, Derivatives derive their values from the assets they represent. Given the constant volatility in today’s market environment, there are always variations of price that asset holders have to deal with. In keeping with the demand and supply equation prevailing at the moment, your assets either increases in value or decreases, exposing your holdings to continued financial risk and loss.

As this risk is constant and a typical attribute of capital market investing, managing this risk and associated uncertainty is extremely important. Derivatives thus help us manage these risks effectively. As derivatives have no independent value of their own, they are traded at the expected values of the assets they represent. Hence, it is also the trading of expected risk and uncertainties. 

Thus, trading in derivatives is also a form of insurance against unexpected price movements, volatility of markets, uncertainties of Company performances and profits.

Summarizing, derivatives allow you to

• Trade on price movements
• Contain risks and uncertainties
• Profit from short term mispricing

a) Hedgers
b) Speculators
c) Arbitrageurs 

In simple terms, hedging would mean the reduction of risk. An investor who is looking at reducing his risk is known as a Hedger. A Hedger would typically look at reducing his asset exposure to price volatility and in a derivative market, would usually take up a position that is opposite to the risk he is otherwise exposed to.

For example, an investor has a portfolio of Rs. 1000000 and wants to hedge ahead of an important event (something like elections, policy announcements, or even the Budget!). Depending on the investor’s requirement; hedging can be done by shorting index futures to make his portfolio beta neutral. Alternatively, the investor can buy put options of the index by paying a fixed cost referred to as premium.

Hedgers primarily look at limiting their exposure risk. This is done by using derivative tools and “insuring” limited losses in case of unfavourable movements in the underlying asset. That brings us to the next group of derivative market participants the Speculators.

As the name suggests, speculators hypothesize expected price movements and take accordant positions that maximize profit. Speculators are extremely high risk takers who are in the Derivative markets merely for the purpose of making profits. They need to effectively forecast market trends to take positions that don’t in any way guarantee safely of invested capital or returns. Speculators rely on fast moving trends to forecast possible market moves these could range from changing consumer tastes to fluctuating rates of interest, economic growth indicators coinciding with market timing etc. Speculators can make huge profits or an equally huge loss and are typically high net investors looking to diversify holding with a view to maximize profits in a short period of time.
 
If a speculator feels the stock price of XYZ Company is expected to fall in the next two days given some upcoming market developments, he would typically short sell these shares in a derivative market without actually buying or owning those shares. Should the stock then fall as expected, he would rake in a sizeable profit depending on his holding. However, should the stock buck expectations, he would make a commensurate loss.
 
The last major participants are the Arbitrageurs. They play in an extremely fast paced environment with decisions being made at a moment’s notice. Sometimes the price of a stock in the cash market is lower or higher than it should be, in comparison to its price in the derivatives market. Arbitrageurs exploit these imperfections and inefficiencies to their advantage. They also play an important role in increasing liquidity in the market thus making it more fluid.

There are various arbitrage opportunities that can be explored in the derivatives market. Cash-Futures arbitrage is one of the simplest forms. If the futures price is trading at a premium to its underlying asset; it is referred to as a Contango. If the premium post adjustment for transaction costs gives higher returns than the cost of capital, an arbitrageur will initiate positions to benefit from this opportunity. The opposite scenario (where Futures are at discount) is referred to as Backwardation.

Derivative markets also include brokers and dealers who represent customers. Every participant individual or represented place their orders at the derivatives exchanges for execution. This central marketplace then provides a platform for information and matching positions for all participants who remain anonymous to ply their trade.

Thus derivatives and its market participants help redistribute risk generated by global and domestic economies. They regulate pricing and protect assets from being excessively over valued or undervalued. Derivative market participants thus keep efficient machinery in place to allow for a smoother and balanced functioning of the equity markets.

Understanding derivatives and what they mean

Understanding Derivatives: Basics of Futures and Options