Equity derivative
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Equity derivatives are financial instruments that derive their value from an underlying asset, such as a stock or index. They enable investors to take a position on the future direction of a stock or index without actually buying or selling the underlying asset. Equity derivatives can be used to hedge against market risk, speculate on future price movements, or generate additional income. Equity derivatives are traded over the counter or through exchanges and can take the form of options, futures, forward contracts, swaps, and other structured products.
Example of equity derivative
- Options: Options are contracts that give the holder the right, but not the obligation, to buy or sell a security at a predetermined price within a certain period of time. Options can be used to speculate on the future direction of a stock or index, or to hedge against market risk. For example, an investor may buy a call option to speculate on a stock index rising, and buy a put option to hedge against a stock index falling.
- Futures: Futures are contracts that obligate the holder to buy or sell a security at a predetermined price on a certain date in the future. Futures are commonly used to speculate on the price of a stock or index, or to hedge against market risk. For example, an investor may buy a futures contract to speculate on a stock index rising, and sell a futures contract to hedge against a stock index falling.
- Forward contracts: Forward contracts are agreements to buy or sell a security at a predetermined price at some point in the future. Forward contracts are commonly used to speculate on the future direction of a stock or index, or to hedge against market risk. For example, an investor may buy a forward contract to speculate on a stock index rising, and sell a forward contract to hedge against a stock index falling.
- Swaps: Swaps are agreements to exchange cash flows between two parties. Swaps are commonly used to speculate on the future direction of a stock or index, or to hedge against market risk. For example, an investor may buy a currency swap to speculate on the exchange rate of a currency, and sell a credit default swap to hedge against a counterparty's credit risk.
- Structured products: Structured products are financial instruments that are tailored to meet the specific needs of an investor. Structured products can be used to speculate on the future direction of a stock or index, or to hedge against market risk. For example, an investor may buy a leveraged index fund to speculate on a stock index rising, and buy a downside protection fund to hedge against a stock index falling.
When to use equity derivative
Equity derivatives can be used in a variety of ways. They can be used to hedge against market risk, speculate on future price movements, or generate additional income. Specifically, equity derivatives can be used for the following:
- Hedging: Equity derivatives are commonly used to hedge against the risk of adverse price movements in the underlying asset. For example, an investor may buy a put option to protect against a potential fall in the stock price.
- Speculation: Equity derivatives can also be used to speculate on the future direction of a stock or index. For example, an investor may buy a call option in anticipation of a rise in the stock price.
- Generating income: Equity derivatives can also be used to generate additional income. For example, an investor may enter into a swap agreement to receive a fixed income stream in exchange for a variable income stream based on the performance of the underlying security.
- Portfolio diversification: Equity derivatives can also be used to diversify a portfolio. For example, an investor may buy a basket of options on different stocks or indices to reduce the overall risk of the portfolio.
Types of equity derivative
Equity derivatives are financial instruments that derive their value from an underlying asset, such as a stock or index. They can take the form of options, futures, forward contracts, swaps, and other structured products. Below are the most common types of equity derivatives:
- Options – an agreement that gives the buyer the right, but not the obligation, to buy or sell an underlying security at a predetermined price and date.
- Futures – an agreement to buy or sell an underlying asset at a specified price on a later date.
- Forward Contracts – an agreement between a buyer and seller to buy or sell an underlying asset at a predetermined price on a later date.
- Swaps – a contract between two parties to exchange cash flows or assets over a period of time.
- Structured Products – a type of financial instrument that combines different types of derivatives to create a customized investment strategy.
Advantages of equity derivative
Equity derivatives offer a range of advantages for investors. These include the ability to:
- Hedge against market risk: Equity derivatives allow investors to take a position on the future direction of a stock without actually buying or selling the underlying asset. This allows investors to reduce their exposure to market risk.
- Speculate on future price movements: Equity derivatives enable investors to make a bet on the future direction of stock prices.
- Generate additional income: Derivatives can be used to generate additional income by taking advantage of price discrepancies between different markets.
- Increase portfolio diversification: Equity derivatives can be used to diversify a portfolio, allowing investors to spread risk across different asset classes.
- Access hard-to-reach markets: Equity derivatives can be used to gain exposure to markets that are otherwise difficult to access.
- Reduce transaction costs: Equity derivatives can help reduce the costs associated with buying and selling stocks.
Limitations of equity derivative
Equity derivatives can be a useful tool for investors, but they also have a number of limitations. These include:
- Counterparty risk - Equity derivatives involve a contract between two parties, and there is a risk that one of the parties may not fulfill their obligations or may become insolvent.
- Liquidity risk - Equity derivatives can be difficult to trade due to their illiquid nature, meaning that they may not be easy to buy or sell when needed.
- Expiration risk - Equity derivatives have an expiration date, so if the underlying asset does not move as expected before the expiration date, the investor may lose money.
- Taxation risk - Equity derivatives may be subject to different tax rules than the underlying asset and can be difficult to understand.
- Volatility risk - Equity derivatives are subject to greater volatility than the underlying asset, so they can be more risky than the asset itself.
Suggested literature
- Linetsky, V. (2006). Pricing equity derivatives subject to bankruptcy. Mathematical Finance: An International Journal of Mathematics, Statistics and Financial Economics, 16(2), 255-282.
