Study Notes

Participants in Derivatives
Market
Participants in Derivatives market

Hedging and Hedgers

Hedging mainly is a risk management strategy.

o Hedging means strategically using financial instruments or market strategies to offset

the risk of any adverse price movements.
o As a strategy, it protects an individual’s finances from being exposed to a risky situation
that may lead to loss of value.
o Hedging doesn’t necessarily mean that the investments won’t lose value at all. Rather, in
the event that happens, the losses will be mitigated by gains in another investment.
o The reduction in risk provided by hedging also typically results in a reduction in potential
profits.

Hedging strategies typically involve derivatives, such as options and futures contracts.

Public futures markets were established in the 19th century to allow transparent, standardized,
and efficient hedging of agricultural commodity prices; they have since expanded to
include futures contracts for hedging the values of energy, precious metals, foreign currency,
and interest rate fluctuations

Hedgers:
Hedgers are investors, they are least risk takers and want to avoid or mitigate the risk
associated with a position. Their intentions are of reducing the risk of adverse price movements
in an asset. Any investor who uses the Hedging strategy is a Hedger.

Example 1:
If you own a home in a flood-prone area, you will want to protect that asset from the risk of
flooding—to hedge it, in other words—by taking out flood insurance.

By taking out a flood insurance, we are not safeguarding the house from flood itself. That is an
event which may or may not occur. But if it occurs the owner will face losses. So to mitigate or
reduce the losses, the owner of the house buys flood insurance.

Let’s assume the flood does occur and the house is completely washed down. In this case, the
there is a complete loss of full investment, but due to insurance part of the loss is recovered.

Example 2:
Let’s assume an investor is holding 100 shares in a company called Infosys. He bought it at
Rs.100/- per share, total value of investment coming to Rs.10,000/-. The investor believes that
the market volatility could cause short-term weakness in the share price of Infosys.

To hedge the equity position, or to say reduce the loss, the investor could look at buying put
options on company Infosys.

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Participants in Derivatives market

Under Put option the investor has the right but not the obligation to sell the Infosys company
shares held as underlying asset in the put option purchased.
He buys the put option at Rs.90/- per share for 100 underlying Infosys shares.
Scenario 1: Price rises:
The premium paid for the option is the only loss in case as he will not sell the his shares.
Scenario 2: Prices decline:
If the share prices drop as the investor was anticipating he will sell the shares at pre –
determined rates Rs. 90/- per share.

Arbitrage and Arbitrageurs

Arbitrage is an opportunistic trade.

o The purchase and sale of an asset in order to profit from a difference in the asset's price
between markets is called Arbitrage.
o It is a type of trade in which a security, currency, or commodity is nearly simultaneously
bought and sold, in different markets
o It mainly exists due to different prices for the same asset in different markets.
o It is a trade that profits by exploiting the price differences of identical or similar financial
instruments in different markets or in different forms.
o Arbitrage exists as a result of market inefficiencies and would therefore not exist if all
markets were perfectly efficient.

Arbitrageurs:
An arbitrageur is an investor who attempts to make profit from market inefficiencies.
These inefficiencies can relate to any aspect of the markets, whether it is price or currencies or
regulations etc.
The most common form of arbitrage is price.
Any investor who indulges in Arbitrage is an Arbitrageur.

Arbitrage is considered to be a risk – free profit for the traders.

Example 1:
The stock of Infosys is trading at $20 on the New York Stock Exchange (NYSE) while, at the
same moment, it is trading for the equivalent of $20.50 on the Bombay Stock Exchange (BSE).
A trader can buy the stock on the NYSE and immediately sell the same shares on the BSE,
earning a total profit of 50 paisa per share, less any trading costs.

Example 2:
You begin with $1 million. You see that at three different institutions the following currency
exchange rates are immediately available:

 Institution 1: 1 USD to Euros = 0.894

 Institution 2: 1 British pound to Euro = 1.276
 Institution 3: 1 British pound to USD = 1.432

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Participants in Derivatives market

1. You would convert the $1 million to euros at the 0.894 rate, giving you 8,94,000 euros
(1000000* 0.894) .
2. You would take the 8,94,000 euros and convert them to pounds at the 1.276 rate, giving
you 700,627 pounds.(894000/1.276 = 700627)
3. Last you would take the pounds and convert them back to U.S. dollars at the 1.432 rate,
giving you $1003,297. (1003297 – 1000000 = $3297)

A risk free profit of $3297 in a time frame of 2 to 3 minutes.

Speculation

Speculation mainly means successful anticipation of the price movement of the asset.
o Speculation is the purchase of an asset (a commodity, goods, or real estate) with the
hope that it will become more valuable in the near future.
o It is also the practice of engaging in risky financial transactions in an attempt to profit
from short term fluctuations
o The motive is to take maximum advantage from fluctuations in the market.
o There are a few differences between speculation and investment.

Speculators: Market players engaging in Speculation are called Speculators.

Example: A market player who invests in IPO of a company intending to sell it once the
company gets listed on the exchange is a speculative trade.

A recent IPO of Burger King for Rs. 810 crore, in December 2020. Shares of Burger King got
listed at Rs 115.35 on BSE, a 92.25 per cent premium over the issue price of Rs 60.
Investor who applied for the IPO and was allotted shares of Burger King at Rs.60/- and sold the
same for Rs. 115.35 on the first day of listing is a Speculator.

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Participants in Derivatives market

A quick summary