Page 25 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes who wants to book a definite known profit on investment. If Mr. A waits, he is speculating on his
position which may expose him to uncertain gain/loss. If Mr. A decides to hedge, he can use one
of the derivative instruments (as discussed above).
Let us discuss in detail, the three market participants in derivative trading.
1. Hedgers: Hedgers are those traders who wish to eliminate price risk associated with the
underlying security being traded. The objective of these kind of traders is to safeguard
their existing positions by reducing the risk. They are not in the derivatives market to
make profits. Apart from equity markets, hedging is common in the foreign exchange
markets where fluctuations in the exchange rate have to be taken care of in the foreign
currency transactions or could be in the commodities market where spiralling oil prices
have to be tamed using the security in derivative instruments.

Example: An investor holding shares of ITC and fearing that the share price will decrease
in future, takes an opposite position (sell futures contracts) to minimize the extent of loss if the
share will to dwindle.
2. Speculators: While hedgers might be adept at managing the risks of exporting and
producing petroleum products around the world, there are parties who are adept at
managing and even making money out of such exogenous risks. Using their own capital
and that of clients, some individuals and organizations will accept such risks in the
expectation of a return. But unlike investing in business along with its risks, speculators
have no clear interest in the underlying activity itself. For the possibility of a reward, they
are willing to accept certain risks. They are traders with a view and objective of making
profits. These are people who take positions (either long or short positions) and assume
risks to profit from fluctuations in prices. They are willing to take risks and they bet upon
whether the markets would go up or come down. Speculators may be either day traders or
position traders. The former speculate on the price movements during one trading day,
while the latter attempt to gain keep their position for longer time period to gain from
price fluctuations.

Example: In the previous example (ITC), it is also possible to short futures without
actually owning shares in spot market. The speculator does so because he expects ITC to fall and
by entering into short futures, he gains if price falls. The speculator is not required to pay the
entire value i.e., (No. of futures contracts × shares under each contract × delivery price). Only
margin money which accounts for 5-10 % of total transacted value is paid upfront by speculator.
Thus, futures are highly levered instruments. For example, if margin money required is 10 %,
the speculator can take 10 contracts by paying the price of 1 contract.
3. Arbitrageurs: The third players are known as arbitrageurs. From the French for arbitrage
or judge, these market participants look for mis-pricing and market mistakes, and by
taking advantage of them; they disappear and never become too large. If you have even
purchased a produce of a green grocer only to discover the same produce somewhat
cheaper at the next grocer, you have an arbitrage situation. Arbitrage is the process of
simultaneous purchase of securities or derivatives in one market at a lower price and sale
thereof in another market at a relatively higher price.

Example: On maturity if the pepper futures contracts is 650 per k.g. and the spot price
is 642, then the arbitragers will buy pepper in spot and short sell futures, thereby gaining
riskless profit of 650-642 i.e., 8 per k.g. Here, the two markets are spot and futures market.
Thus, riskless profit making is the prime goal of arbitrageurs.

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