note: contd from the previous post "Learning 1"
M came up with a basic question “Why did the concept of derivatives come in picture and what is it by the way”
Me:“Well, as you know financial markets are volatile in nature. Volatility would then mean involvement of high level of risk. It is this risk factor that becomes a concerning factor to the financial agents. To negate or possibly lower the risk, the concept of derivatives came into existence.
Now to your second question, Let us rewind ourselves to the years when we studied mathematics in school. If you remember, in mathematics, when we started learning derivatives, we understood that derivative – by itself does not have any value and that it derives its value from the preceding one. Like wise, in financial terms, a derivative is nothing but a financial instrument that derives its value from an underlying asset. The derivative here does not have any meaning by itself, but it acquires its value from the asset that it is based on. The underlying asset can be livestock, bullion, currency etc.
I hope that you have got this definition right.
M: That is nice buddy. Thanks – but how does this negate or lower the risk
Me: Ok. To understand let me explain the concept of hedging and futures. I am hopeful that you can understand the market terminology to some extent. Assuming the answer to be yes, let me try to make my explanation as lucid as possible. Basically, here there are two markets. One is the futures market and the other is the physical market. Now, the concept of hedging says, take a position in futures market opposite to that of physical market. Take an opposite position would then nullify the risks that arise.
M: Sorry Narasimhan. Can you explain with an example?
Me: Ok, imagine that I am an automobile manufacturer. Now I have already decided on the pricing of my automobile in the market. Obviously, the pricing would depend on raw materials which can include say – Steel. And this I would have done based on the present prices of steel in the market (Taking into consideration the projection prices of steel in the market as well)
Now, how sure I am that the steel prices would not increase after 6 months. (Beyond the projected pricing as well) An increase in steel prices (In physical market) would drain out my profit margin that I have estimated. Thus to negate this risk, I buy steel futures (in futures market). This means that I buy future contract (derivative) whose value will depend on the underlying asset (steel).
Now let us take up different possibilities to show how buying steel futures benefit the automobile manufacturer.
Case 1: Assume that the steel prices go up appreciably in the physical market. This would mean that automobile manufacturer would incur loss (if he had not bought the steel futures) . Now, since the steel prices have gone up, the rate of steel futures also goes up. This mean the loss that is seen in physical market is well compensated in the futures market – as the automobile manufacturer gains from the increase in steel futures. (This is what I meant taking a position in futures market opposite to that of physical market)
Case 2: Likewise, if the price of steel goes down in the physical market, it does not have an impact on him, as he is going to make a profit anyway.
This concept would technically mean, hedging and this how derivatives help in minimizing the risk.
M: This is nice and great. Thanks and what about other type of derivatives that you were saying?
Me: Well basically, you have futures, forwards, options, Interest rate swaps, baskets, leaps and swapations. And adding to it, you should also understand who are the players in this market, margin, mark to market concept, strike price, premium, discount and various other things. This being a party, I would not like to make it very detailed. Let us hold up a separate session for this alone. What do you say?
M: It is fine with me. Thanks
Me:“Well, as you know financial markets are volatile in nature. Volatility would then mean involvement of high level of risk. It is this risk factor that becomes a concerning factor to the financial agents. To negate or possibly lower the risk, the concept of derivatives came into existence.
Now to your second question, Let us rewind ourselves to the years when we studied mathematics in school. If you remember, in mathematics, when we started learning derivatives, we understood that derivative – by itself does not have any value and that it derives its value from the preceding one. Like wise, in financial terms, a derivative is nothing but a financial instrument that derives its value from an underlying asset. The derivative here does not have any meaning by itself, but it acquires its value from the asset that it is based on. The underlying asset can be livestock, bullion, currency etc.
I hope that you have got this definition right.
M: That is nice buddy. Thanks – but how does this negate or lower the risk
Me: Ok. To understand let me explain the concept of hedging and futures. I am hopeful that you can understand the market terminology to some extent. Assuming the answer to be yes, let me try to make my explanation as lucid as possible. Basically, here there are two markets. One is the futures market and the other is the physical market. Now, the concept of hedging says, take a position in futures market opposite to that of physical market. Take an opposite position would then nullify the risks that arise.
M: Sorry Narasimhan. Can you explain with an example?
Me: Ok, imagine that I am an automobile manufacturer. Now I have already decided on the pricing of my automobile in the market. Obviously, the pricing would depend on raw materials which can include say – Steel. And this I would have done based on the present prices of steel in the market (Taking into consideration the projection prices of steel in the market as well)
Now, how sure I am that the steel prices would not increase after 6 months. (Beyond the projected pricing as well) An increase in steel prices (In physical market) would drain out my profit margin that I have estimated. Thus to negate this risk, I buy steel futures (in futures market). This means that I buy future contract (derivative) whose value will depend on the underlying asset (steel).
Now let us take up different possibilities to show how buying steel futures benefit the automobile manufacturer.
Case 1: Assume that the steel prices go up appreciably in the physical market. This would mean that automobile manufacturer would incur loss (if he had not bought the steel futures) . Now, since the steel prices have gone up, the rate of steel futures also goes up. This mean the loss that is seen in physical market is well compensated in the futures market – as the automobile manufacturer gains from the increase in steel futures. (This is what I meant taking a position in futures market opposite to that of physical market)
Case 2: Likewise, if the price of steel goes down in the physical market, it does not have an impact on him, as he is going to make a profit anyway.
This concept would technically mean, hedging and this how derivatives help in minimizing the risk.
M: This is nice and great. Thanks and what about other type of derivatives that you were saying?
Me: Well basically, you have futures, forwards, options, Interest rate swaps, baskets, leaps and swapations. And adding to it, you should also understand who are the players in this market, margin, mark to market concept, strike price, premium, discount and various other things. This being a party, I would not like to make it very detailed. Let us hold up a separate session for this alone. What do you say?
M: It is fine with me. Thanks
Me: Thanks.And may I take your permission to put forth our discussions in my blog, so that others can also benefit and that it also becomes a revision to me.
M: Sure, you don’t need my permission sir.
Me: Ok, I am hitting the floor and mate thanks for the party once again.
Cheers and adios for now….
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