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Context:

IndusInd Bank reported derivative losses of Rs 2,100 crore, which dragged down its share price by 23%

What are Derivatives?

Derivatives are financial instruments whose value derives from an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, or market indices.

It allows parties to trade the risk or reward associated with the underlying asset without holding it directly.

Traders use derivatives to hedge risks, speculate on price movements, or gain exposure to assets indirectly. For example, a futures contract allows a farmer to lock in the price of wheat today for delivery in six months, reducing uncertainty about future prices.

Main types of derivatives

The main types of derivatives include futures, options, swaps, and forwards.

• Futures contracts obligate buyers and sellers to transact at a predetermined price and date.
• Options give holders the right, but not the obligation, to buy or sell an asset at a specific price.
• Swaps involve exchanging cash flows or liabilities between two parties, often to manage risks like interest rates or currencies
• Forwards function similarly to futures but are customized and traded over-the-counter rather than on exchanges.

Why do investors use derivatives?

Investors use derivatives to achieve several objectives.

• They hedge risks by locking in prices or rates to protect against adverse market movements.
• They speculate on price changes to profit from volatility without owning the underlying asset.
• They use derivatives to arbitrage price discrepancies between markets.

Derivatives allow traders to control large positions with relatively small capital. For example, an investor might buy call options on a stock to benefit from potential price increases while limiting losses to the premium paid.

Source:

INDIANEXPRESS

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