Derivatives and Hedging1. What Are Derivatives?
A derivative is a financial contract whose value is “derived” from an underlying asset.
The underlying can be:
Stocks
Indices (Nifty, Sensex, Dow Jones)
Currencies (USD/INR)
Commodities (gold, oil, silver)
Interest rates
Bonds
Cryptocurrencies
A derivative’s price depends on the price movement of these underlying assets.
Example:
If you buy a derivative contract on crude oil, the value of the contract changes with crude oil prices.
Derivatives are used for:
Hedging (reducing risk)
Speculation (betting on price movement)
Arbitrage (risk-free profit between markets)
Leverage (control large positions with small capital)
2. Why Derivatives Exist
Every market has uncertainty. Prices rise and fall due to:
Supply and demand
Economic conditions
Inflation
Geopolitical tensions
Monetary policies
Weather conditions (important in agriculture)
Derivatives allow traders and businesses to lock in costs and revenues, giving certainty and stability.
Example:
An airline uses derivatives to lock oil prices because fuel cost is a major expense.
A jeweller uses gold futures to secure gold price months in advance.
Thus, derivatives reduce uncertainty and protect profitability.
3. Major Types of Derivatives
There are four major types of derivatives:
3.1 Futures
A future is a legally binding contract to buy or sell an asset at a fixed price on a future date.
Features:
Traded on exchanges (NSE, BSE, CME)
Standardized contracts
Requires margin (not full payment)
Daily mark-to-market adjustments
Example:
Buying Nifty Futures at 24,000 means you commit to buy it on expiry at that price.
If Nifty rises to 24,500, you gain.
If falls to 23,500, you lose.
3.2 Options
An option gives you the right but not the obligation* to buy or sell an asset at a pre-decided price (strike price).
Two types:
Call Option – Right to buy
Put Option – Right to sell
Options buyers pay a premium, while sellers (writers) receive premium.
This is the most popular derivative instrument for hedging and speculation.
Example:
Buying a put option protects your stocks if the market falls.
This acts like an insurance policy.
3.3 Forwards
A forward contract is like a futures contract but traded privately (OTC – over the counter).
Features:
Custom agreements
Not exchange traded
Higher counter-party risk
Flexible terms
Used widely in:
Export/import business
Banks
Corporates managing currency and interest rate risk
3.4 Swaps
A swap is an agreement to exchange cash flows.
Most common types:
Interest Rate Swaps
Currency Swaps
Commodity Swaps
Example:
A company with a floating interest loan can swap it with a fixed rate to reduce risk.
4. What Is Hedging?
Hedging = Reducing or managing financial risk.
It involves taking a position in the derivative market opposite to your existing exposure.
The purpose is not to make profit, but to protect against loss.
Example:
If a farmer expects wheat prices to fall, he sells wheat futures to lock a price.
If a stock investor fears market correction, he buys put options for insurance.
Hedging is like:
Wearing a helmet while riding
Buying fire insurance for a factory
Airbags in a car
You hope not to use it, but you are protected when something goes wrong.
5. How Hedging Works (With Examples)
5.1 Stock Market Hedging
Suppose you have a portfolio worth ₹10 lakh and fear a short-term correction.
You buy a Nifty Put Option.
If the market falls:
Your portfolio loses value
But your put option gains
Losses get balanced
Your overall impact becomes minimal
This is called portfolio insurance.
5.2 Commodity Hedging
A gold exporter wants to lock selling price.
He sells gold futures at ₹62,000 per 10g.
If gold falls to ₹60,000:
He loses in physical market
Gains in future market
Net impact = protected revenue
5.3 Currency Hedging
An importer has to pay USD 1 million after 3 months.
He fears USD may rise and increase his cost.
He buys a USD/INR futures contract.
If USD rises:
He pays more in real world
Gains from USD futures
Total cost remains stable
5.4 Interest Rate Hedging
A company with floating-rate loans fears interest rates will rise.
Solution: Interest Rate Swap
They swap floating rate with fixed rate.
If rates rise, their cost stays fixed.
6. Why Hedging Is Important
Hedging ensures:
Stability of business profits
Predictable cash flows
Protection from catastrophic losses
Avoiding market shocks
Better planning and forecasting
In global markets, companies face:
Exchange rate volatility
Commodity price swings
Inflation
Interest rate fluctuations
Hedging becomes essential for survival.
7. Hedging vs Speculation
Aspect Hedging Speculation
Purpose Reduce risk Make profit
Risk Low High
Approach Opposite market position Same direction market bet
Used by Corporates, exporters, investors Traders
Profit Expectation Limited or none Unlimited potential
Hedgers use derivatives to protect themselves.
Speculators use derivatives to make gains.
Both together create market liquidity.
8. Advantages of Derivatives
Risk management
Price discovery
High liquidity
Low cost trading
Leverage enables big trades with small capital
Opportunity to short market easily
Global market linkage
Derivatives make markets more efficient and enable smoother functioning of financial systems.
9. Risks of Derivatives
While powerful, derivatives carry risks:
Leverage amplifies losses
High volatility
Complex structures
Counter-party risk in forwards
Regulatory risk
Potential for misuse
Over-speculation causing market stress
This is why exchanges enforce:
Margin systems
Position limits
Daily settlement
Strict surveillance
10. Role of Derivatives in Global Markets
Derivatives are vital for:
Managing global trade risks
Stabilizing prices for commodities like oil, gold, wheat
Supporting financial institutions
Allowing global investors to hedge international exposure
Facilitating cross-border capital flow
Every major economy relies on derivatives to maintain financial stability.
Conclusion
Derivatives and hedging are core pillars of modern finance.
Derivatives derive value from underlying assets and are used for hedging, speculation, and arbitrage.
Hedging protects against adverse price movements, offering stability to investors and businesses.
Though derivatives involve risks, proper use creates balance, efficient markets, and reduced uncertainty.
Whether you are an investor, trader, or business, understanding derivatives and hedging is essential for navigating today’s dynamic financial environment.
