Equity Derivatives
What are equity derivatives?
Equity derivatives are contracts whose value is linked to the value of the underlying asset, i.e. stocks, and are generally used for hedging or speculation purposes. There are four main types of equity derivatives, namely: futures and futures,
options, warrants and exchanges.
The 4 Main Types of Equity Derivatives
We discuss the following four types of equity derivatives.
Forwards and Futures
These are contracts that establish an obligation for the buyer to buy a certain security at a predetermined rate and date. Futures
are more flexible than futures contracts in terms of determining the underlying security, quantity of securities and date of trade. However, futures contracts are standardized and traded.
Options
Gives the buyer the right to buy or sell the underlying stock at a predetermined price at a predetermined rate. Exposure to options is limited to the cost of an option because it is not mandatory to execute the contract at maturity.
Warrants
Like options, warrants also give the right to buy or sell a share at a predetermined date and rate.
Example
An investor has a position in ABC derivatives limited to 50. He can enter into a swap agreement, in which the financial obligation under that derivative is exchanged for the return of another derivative. On the predetermined date, both parties extinguish the current obligation or can settle it in differential cash.
Advantages of equity derivatives
Some of the advantages of equity derivatives are as follows:
Since the value of the derivative is linked to the underlying asset (equities), it is used to cover the exhibition. An investor holding shares can enter into a derivative contract for the same participation whose value changes in the opposite direction. In this way, any loss can be offset by profits in others.
The portfolio risk is allocated between the security and the derivative.
Disadvantages of Equity Derivatives
Some of the disadvantages of equity derivatives are as follows:
High volatility exposes you to the risk of huge losses on derivatives.
Derivatives are used for speculative purposes and, due to uncertainty, unreasonable speculation can lead to huge losses.
When derivative contracts are entered into over-the-counter, there is a risk of counterparty default.
Conclusion
Equity derivatives are contracts whose value is linked to the value of the underlying
Equity derivatives are used for hedging or speculation purposes.
There are four types of equity derivatives: forwards/futures, options, warrants and swaps.
