Equity Derivative

Equity derivatives are contracts whose value is linked to the value of the underlying asset, i.e., equity, and are usually used for hedging or speculation purposes. There are four main types of equity derivatives, namely - forwards and futures, options, warrants, and swaps.

It is widely used for the purpose of hedging, speculation, gaining market exposure and taking complex trades by investors and traders. They investors do not have to own the assets to take the trades but can take advantage of price fluctuations to earn profits.

• Equity derivatives are financial instruments whose value is derived from the price movements of underlying equities, such as stocks or shares.
• Equity derivatives provide investors with opportunities to hedge against market risks, speculate on price movements, and gain exposure to a specific equity or basket of equities.
• Common types of equity derivatives include equity options, equity futures, equity swaps, and equity warrants.
  Equity derivatives are widely used by institutional investors, traders, and individual investors for various investment and trading strategies.

Equity derivatives are contracts whose value is linked to the value of the underlying asset. They are used for hedging or speculation purposes. They are of four types: forward/future, options, warrants, and swaps.

This kind of financial instrument can be advantageous due to the fact that there is diversification of portfolio. Equity derivative trading can also be used for effectively controlling risk of investment and design strategies with maximum profit with minimum loss. However, there are some disadvantages inherent to the concept, like the counterparty risk, high volatility of the financial market and complexity of the instrument.

The various types include equity related forwards and futures related to equity, options, swaps and warrants of equity. They are explained below in details.

It is possible to trade in them only when the trader has a strong understanding of the concept, skill to analyse the market and knowledge regarding the potential impact of the instrument and equity derivative trading on their portfolio.

Let's discuss four types of equity derivatives are as follows.

#1 - Forwards and Futures

These are the contracts that set an obligation for the buyer to buy specified security at a predetermined rate and date. Forward contracts are more flexible than futures in terms of determination of underlying security, a quantity of security, and date of transaction. However, futures contracts are standardized and traded on the stock exchange.

We can understand the details from the chart given below, in which the short position payoff is K-ST and the long payoff is ST -K, where the ST is the spot price of the underlying asset, K is the delivery price that the parties agree. Fora long position, a higher maturity price will be more profitable, and for a short position, it will be the opposite.

#2 - Options

It is based on equity indices representing a basket of stocks which track a particular market or sector performance. It provides the right to the buyer to purchase or sell the underlying equity at a predetermined price on a predetermined rate. The exposure in options is limited to the cost of an option as it is not obligatory to execute the contract on maturity. However the investor can have exposure to the larger part of market movement rather than trading in individual stock, which is risker.

The charts related to option payoff will help in understanding the concept. In the charts below, for a long call option, the trader will be able to earn profits only when the underlying asset’s price is higher than the strike price. There is no profit till the level the price of the asset is less than the strike price. For a long-put option, if the price of the underlying is more than the strike price, there is no intrinsic value. Therefore, profits increase as the price of the underlying asset becomes less or falls below the strike price, as shown in the figure.

#3 - Warrants

Like options, warrants also give a right to purchase or sell a stock at a trained date and rate. Warrants are issued by companies and not the third party.

#4 - Swaps

These are the contract between two parties to exchange the financial obligation in the derivative contract. The cash flows are exchanges between the two parties based on the equity instrument performance which is the underlying asset. One party pays a series of cash flow to another that is tied to dividend payment or capital appreciation of a stock or index.

The following are examples of equity derivative products.

Example #1

An individual bought ten equity shares worth $10 each (with a total cost of $100). He also bought a call option of $10 with a strike price at $0.50, total cost coming to $5 ($0.50 x 10 shares). If the share price increases to $11, the option will give a gain of $1. However, if the price drops down to $9, there would be a loss of $1 on each share, so the individual will not avail the option. Therefore, in this case, the profits can be unlimited, but the losses are limited to the cost of the option, i.e., $5.

Example #2

Here is another example of equity derivative sales. An investor holds 1,000 shares of Beta Limited and wants to sell them after 30 days. Since there is the uncertainty of price after 30 days, he enters into a forward contract to sell after 30 days at a price determined today. After 30 days, irrespective of the market price, the investor will have to deliver the stock to the counterparty at the predetermined price. The equity forwards can be deliverable in the form of either stock or cash-settled.

Example #3

An investor has a position in ABC limited 50 derivatives. He can enter in a swap agreement, where financial obligation under this derivative is exchanged for return on some other derivative. At the predetermined date, both the parties will settle the obligation in actual or can settle the same in differential cash.

Thus, the above examples show some situations where the financial instrument is used for trading of equity derivative sales purpose, the possibility of gains and losses and how they affect the portfolio.

Some of the advantages of equity derivative are as follows:

• Hedging Risk Exposure: Since the value of the derivative is linked to the underlying asset (equity), it is used for hedging the exposure. An investor holding equity shares can enter in a derivative contract against the same equity whose value moves in the opposite direction. This way, the losses, if any, can be set off with profits in others.
• Distribution of Risk: The portfolio risk is distributed amongst the security and derivative. Therefore it limits the exposure of risk in equity derivative products by gaining exposure to a wider range of market indices and stocks without actually investing in them.
• Low Transaction Cost: The cost of derivative contracts is low in comparison to the risk they cover.
• Determination of Price for Underlying Equity: Sometimes, the spot price of the futures is used to determine the approximate price of the security. Thus, it gives an exposure to the sentiments of the market participants.
• Efficiency - It helps in increasing market efficiency.
• Flexibility – There is flexibility of investment in equity derivative products through various designing of strategies and structures that is suitable for the investor’s risk-taking capacity and outlook of the market. The traders can execute any kind of trades like bullish, bearish or neutral strategies.

Some of the disadvantages of equity derivative are as follows:

• High Volatility Risk: High volatility exposes to the risk of huge losses in derivates.
• Equity Derivatives are Speculative in Nature: Derivatives are used for speculation, and due to uncertainty, unreasonable speculation can result in huge losses both for equity derivative analyst and investors.
• Risk of Default by Counterparty: When derivative contracts are entered over the counter, there is a risk of default by the counterparty.
• Complex instrument – They are complex instruments that require skill, knowledge and understanding to trade. The investor should be aware of the various market dynamics, pricing models, and strategies to manage risk of losses before indulging into the trading process.
• Regulations – This market is subject to various rules and regulations that keep on changing from time to time. This impacts the trading and market conditions, the marines required to trade and the possibility of accessing the market.
• Manipulation- This market is often faced with manipulation by traders who want to make quick profits. They have the ability to distort prices and create market disturbances that affect investors negatively.
• Holding period – There are some derivatives that expire after a certain period. Thus, they offer limited flexibility and possibility of investments.

Thus, it is necessary to have proper skill and knowledge about a financial instrument before becoming an equity derivative analyst and trading in it and understand the pros and cons of the concept so that it may be implemented and used in the correct place at the right time. This will ensure the maximisation of profit and proper control over the risk of losses.

This has been a guide to what are equity derivatives. We explain its different types, along with examples, advantages and disadvantages. You can learn more from the following articles -

• Call Options vs. Put Options
• Cash Settlement vs. Physical Settlement
• Compare - Options vs. Warrants
• Futures vs. Options