What are Equity Derivatives?
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, optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date., warrants, and swaps.
Top 4 Types of Equity Derivatives
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 contractsForward ContractsA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price). 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 exchangeTraded On The Stock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ..
#2 – Options
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.
#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.
Examples of Equity Derivatives
The following are examples of equity derivatives.
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 priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. 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.
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.
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.
Advantages of Equity Derivatives
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.
- 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.
- It helps in increasing market efficiency.
Disadvantages of Equity Derivatives
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.
- Risk of Default by Counterparty: When derivative contracts are entered over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments., there is a risk of default by the counterparty.
- Equity derivatives are contracts whose value is linked to the value of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates..
- Equity derivates are used for hedging or speculation purposes.
- Equity derivatives are of four types: forward/future, options, warrants, and swaps.
This has been a guide to what equity derivatives are and their meaning. Here we discuss examples and types of equity derivatives along with advantages and disadvantages. You can learn more from the following articles –