In finance, equity derivatives are derivatives that derive their value mainly from the price of stocks. They are often used by investors to hedge against market fluctuations and obtain leverage. There are two types of equity derivative contracts: call options and put options. Put options give the buyer the right to sell at a certain price in the future, while call options give the buyer the right to buy at a certain price in the future.
An Equity Derivative according to Fintalent’s equity derivatives consultants, is a financial contract which pays out a return in relation to the performance of an underlying stock or index that you own or care about. They are most commonly used by large institutional investors who have large portfolios and make complex trading decisions across many different stocks, commodities, indices and asset classes every day.
The basics of derivatives
A derivative is a contract between two parties based on the future value of an underlying asset or group of assets. The parties agree to exchange something of value now in return for something of value at a later date, where the terms of the exchange are determined by the underlying asset’s price. The underlying asset doesn’t need to be something tangible either – it can be an index, another financial instrument (see: credit derivatives), or even an event that hasn’t happened yet.
Adding an element of risk
The reason lots of people enjoy sports betting is because it’s a game of chance; there’s no sure way to predict the final score, so it’s all down to luck. This is unlike betting on fixed odds events like horse races where there are proven odds for you to back a horse at so many times. But let’s say you could find someone who feels the outcome is more down to chance and, therefore, more risky than even your own forecasts. A derivative is a contract between two parties, where one party has taken on the risk of another party taking on the risk. Two types of derivatives exist: forwards and futures.
Futures are bets on the future value of an asset or group of assets, such as what will happen with something in six months time. Futures contracts are usually denominated in dollars but can also be denominated in other currencies. For example, one might bet on what is likely to happen with the exchange rate between the US dollar and its counterpart over next six months (see below).
Futures contracts are made up of an exchange and two sides to the contract; a buyer and a seller. The buyer is the party who believes that the underlying asset will rise in price. The seller, who is betting on it going down, stands to gain more than they stand to lose (in terms of what they gain versus what they lose).
Forward contracts are bets on the future value of an asset or group of assets at a later point in time. Forward contracts are often denominated in foreign currency, in which case one stands to gain or lose based on movements in exchange rates (see below). This allows you to reap the benefits of interest rate differentials between countries, but with less risk compared with holding bonds.
Different types of derivatives
There are two common types of derivative – equity-based and debt-based.
Equity-based derivatives: An equity derivative is an agreement between two parties, where one party agrees to exchange a share in a company or other security for money at some point in time. This could be through a call option or a put option (see below). The value of equity derivatives can rise as well as fall; they’re also known as “over-the-counter” products.
Debt-based derivatives: A debt derivative is an agreement where the value of the agreement will rise if the value of a particular asset increases. This could be a loan that becomes repayable at a specified date, or an interest payment which becomes due at a specified date. Debt derivatives are often used to hedge against fluctuations in interest rates.
Derivatives can be used as collateral for funding and as leverage for organisations, such as banks or hedge funds, to manage risk. This differs from borrowing where you’re relying on the security of your own assets; with derivatives you’re relying on someone else’s assets (typically someone else’s money).
A Brief Introduction to Equity Derivatives (Put Options vs Call Options)
Equity derivatives are securities which derive their value mainly from stocks. Such financial instruments include put options and call options. Both of these are derivatives, which are securities whose values are derived largely from the value of another underlying security. Since they derive their value mainly from stocks, they serve as hedging tools for investors when stock prices fluctuate.
A call option is a contract which gives its owner the “right” to buy a stock at a certain price in the future. It is a derivative of equity (stock) because it will rise in value if the market price of the underlying stock rises above the predetermined strike price. Conversely, the option will become worthless if, at expiry date of the contract, “stock” price is below or equal to strike price.
Under the put option, the owner of a call option may grant the owner of a put option right to sell a stock at a predetermined future date. If the strike price is fixed and the stock price at that time is higher than that strike price, then the owner of a put option will benefit from an increase in value of his/her investment. Conversely, if the stock falls in value below strike price then put holder will be able to realize their investment without incurring any loss.
A put option is a derivative of equity because the option’s value rises as the underlying security depreciates in value. The put writer (seller) makes a profit if the price of the underlying debt of the option goes above his/her strike price. If it does not do so, then he/she will incur a loss.