Hedging - F&O - Futures and Options EXPLAINED | Derivates | Indian Economy for UPSC

Summary

In this video, the speaker explains the concept of derivatives using everyday examples like shoes and tokens. The focus is on futures contracts, which allow individuals to lock in prices and manage risks in the face of market price fluctuations. Through relatable scenarios, such as buying shoes and hedging in the stock market, the video illustrates how futures help reduce uncertainty and provide financial protection. The speaker also hints at discussing options as another tool for risk management in the next video, making it an insightful introduction to financial risk strategies.

Takeaways

• 😀 Derivatives are financial instruments whose value is derived from underlying assets like stocks, bonds, or commodities.
• 😀 A token for shoes at the temple is a simple example of a derivative, where the value of the token depends on the price of the shoes.
• 😀 Futures and options are the two main types of derivatives that allow risk management in the financial market.
• 😀 A futures contract is an agreement where both parties commit to buy or sell an asset at a set price on a future date.
• 😀 Futures contracts help to hedge against price fluctuations and reduce risk by locking in a price ahead of time.
• 😀 The person signing a futures agreement does so to mitigate risk, not necessarily for profit, ensuring stability in fluctuating markets.
• 😀 In a practical example, a futures agreement allows someone to buy shoes for ₹5500 even if their price increases, preventing unexpected costs.
• 😀 Futures can also be used in the stock market, such as for managing risk on stocks like Adani Ports amidst market volatility.
• 😀 If a stock price falls, futures can be used to secure profits or limit losses by selling at a set future price.
• 😀 Futures contracts help to hedge against potential market trends, providing certainty in uncertain situations, whether the market goes up or down.

Q & A

What are derivatives, and how do they work?

Derivatives are financial instruments whose value is derived from an underlying asset like stocks, bonds, gold, or commodities. The price of a derivative fluctuates based on the price changes of its underlying asset. In the script, the token received for shoes in exchange for leaving them at the temple is an example of a derivative.

What is the relationship between the value of derivatives and underlying assets?

The value of derivatives is directly tied to the price of the underlying assets. If the price of the underlying asset increases, the derivative's value increases, and vice versa. For instance, if the price of shoes increases, the value of the token (derivative) also increases.

What are the two main types of derivatives?

The two main types of derivatives discussed in the script are futures and options. These are commonly used to hedge risks or speculate on the future prices of assets.

How does a futures agreement work?

A futures agreement is a contract where two parties agree to buy or sell an asset at a predetermined price at a future date. In the script, the agreement between the person and the speaker to buy shoes for ₹5500 after 30 days is an example of a futures contract, which helps reduce the risk of price fluctuations.

Why would someone enter into a futures agreement if they are not looking to profit?

The person entering the futures agreement is likely doing so to avoid the risk of price fluctuations. They may not be looking for profit but instead want to secure a set price for the asset in the future, ensuring they can afford it despite potential price increases.

How did the futures agreement in the shoe example benefit both parties?

In the shoe example, the speaker benefits by selling the shoes for ₹5500, earning ₹500 profit. The other party benefits by securing the shoes at ₹5500, which protects them from a possible price increase. The key benefit is risk mitigation, not immediate profit.

What role does risk management play in futures contracts?

Futures contracts allow individuals to lock in prices and manage risks associated with price fluctuations. For example, if someone is unsure about future price movements, they can use a futures contract to secure a price and protect themselves from unpredictable market changes.

Can futures agreements lead to both profits and losses?

Yes, futures agreements can lead to both profits and losses, depending on how the price of the underlying asset moves relative to the agreed-upon contract price. If the asset's price increases, a buyer benefits; if it decreases, they may incur losses.

How can someone use futures contracts to hedge against falling stock prices?

As seen in the script, if someone owns stocks that are falling in value, they can sell futures contracts to lock in a price and offset potential losses. This is an example of using futures contracts to hedge against downside risk in the market.

What happens if the market price of the asset moves in the opposite direction of what was expected in a futures contract?

If the market price moves in the opposite direction of what was expected, the person who entered the futures contract may incur a loss. However, in the example from the script, even if the stock price rises unexpectedly, the individual can still profit from their original asset, mitigating losses.