An equity derivative is a type of financial instrument. The value of an equity derivative is derived from the price movement of an underlying asset. Investors use equity derivatives to speculate or hedge against the downside of their investment. The hedge to mitigate the risk associated with taking a long position or short position. Equity option and equity index futures are two forms of equity derivatives. A stock option is a good example of an equity derivative because the value of the stock option is based on the price movements of the underlying stock.
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WHAT ARE EQUITY DERIVATIVES:
Equity derivatives are financial instruments whose value is derived from the price movement of an underlying asset. Equity options and equity index futures are forms of equity derivatives. In a futures contract, the equity derivatives act as an agreement between buyer and seller to either buy or sell the asset at a specific price in the future. The investors are obligated to buy or sell the asset at the expiry of the contract. In options, the investors have the rights but not the obligation to buy or sell the asset. Investors use equity derivatives to mitigate risk by hedging or they speculate and make large gains or losses.
Since equity derivatives are valued based on the price movements of the underlying asset. Investors must understand the characteristics of equity derivatives before making an investment. Following are some of the features of equity derivatives.
- Equity derivatives are used by investors as hedging instruments to mitigate the risk associated with a long or short position. Some investors enter into an equity derivative transaction based on pure speculation where they either make large profits or losses. Option, futures, forwards, convertible bonds, warrants are different types of equity derivatives.
- In a futures contract of equity derivative, there is a buyer and a seller. The gains and losses are adjusted daily i.e., it is marked to market. The initial margin of the contract is based on the size of the contract. At the expiry of the contract, the investors are obligated to close out their positions.
- An equity option consists of an option buyer and writer. The option buyer holds the long position in the contract whereas the option writer holds a short position.
- When buying an option investor needs to pay a premium and while selling a margin amount needs to be deposited. In an equity option, the price paid to buy the option is known as premium and the pre-specified price is called the strike price.
VARIOUS TYPES/ EXAMPLES OF EQUITY DERIVATIVES:
An option is a type of equity derivative. An option holder has the right but not the obligation to buy or sell the particular stock at the specified price. The option contract consists of a pre-specified price also known as the strike price, expiration date, and the terms of the contract. An option contract is often used by the investor as a hedging instrument to protect themselves from the downside risk of their investment. There are two types of option style i.e., American option and European option.
A futures contract is an agreement between a buyer and seller. In a future contract, the investors are obligated to buy or sell the underlying asset at a specified price, at the given expiry date. Futures contracts are traded on the secondary market and are settled daily.
Warrants are similar to options but they are issued by the company itself. They are traded in the over-the-counter market more than they are traded on exchanges. Warrant holders have the rights but not the obligation to sell the particular asset. Investors cannot short warrants like they can options.
Forwards contracts are similar to futures contracts. The only difference between them is forward contracts are traded in the over-the-counter market and are negotiable and tailored as per the party’s requirement.
- CONVERTIBLE BONDS
A convertible bond is a fixed-income corporate debt security. It yields interest payments but can be converted into shares of the company. Convertible bonds consist of a conversion rate and price. They pay lower interest as compared to normal bonds
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Equity derivatives bring us many benefits but there are some risks faced by the investors. The risks involved are interest rate risks. This risk arises when the investors enter into a contract expecting the interest rates to rise in the future but due to some situation the chances of rates falling increases. The other type of risk is currency risk which arises from the fluctuating currency rates. The risk is associated with the gain or fall in price or it trades in the opposite direction of what the investors expect.
Commodity risk arises when the investors as taken a long position in a commodity derivative but due to some reason, the price of that commodity falls in the future. This will increase the investor’s downside risk.
Equity derivatives are contracts between two parties to either buy or sell the underlying asset at a specified price in the future at the given maturity date. The value of an equity derivative is derived from the price movement of an underlying asset. Option, futures, forwards, convertible bonds, etc are types of equity derivatives. The currency risk, commodity risk, and interest rate risks are some of the risks involved in a derivative transaction. Equity derivatives can be used to mitigate risk by hedging or investors may use them for speculation purposes.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.