Derivatives as hedging instrument

TNN, Oct 6, 2006, 11.22am IST

There are several investment instruments available in the market that includes bank fixed deposits,
mutual funds, stocks, property etc. Risk of investment is the difference between the investor's expected
return and the actual return. There are several factors that contribute to the overall investment risk –
interest rate, inflation, business environment, exchange rate fluctuations, market risk etc.
Investment diversification is one popular way to reduce the investment risk. Another way to reduce risk is
by investing in another instrument that cancels out the price variation risk of your investments. This
method of reducing risk is called as hedging. Derivates are popular financial instrument used in foreign
markets from the last several decades for hedging. Derivates are recently introduced in Indian markets.
They are market-created financial products. In simple terms, a derivate is a contract between two parties
(individuals or institutions) with respect to a certain underlying security (asset). Futures and options are
the two most popular derivate products. Commonly-traded derivates available in the market includes
stock futures, stock options, stock index (NIFTY) futures and options, commodity futures (gold, crude oil,
wheat, sugar etc), currency options, interest rate futures and options etc.

A future is an agreement to buy or sell a certain underlying asset at a fixed price and future date. The
seller of future has an obligation to deliver the underlying asset to the buyer of future and the buyer has an
obligation to pay the agreed price to the seller at future date. A transaction involving the sale of stock
futures while holding the position in stock is called short hedge. On the other hand, a transaction
involving the purchase of stock futures to lock-in at current prices is called long hedge. Similarly,
commodities traders can use short/long hedging strategies in commodities market to cover the risk
against the possible commodity price variations.