Derivatives can be used to protect your wealth against swings in interest rates, the rupee or stock markets

Derivatives were termed weapons of mass destruction by Warren Buffet, but that does not mean that you have to look at them with suspicion.

It is true that these have been the cause of the downfall of large as well as small players from Wall Street behemoths such as Lehman Brothers to the small traders who think a quick buck can be made through derivatives trades. The fault lies in the design of these securities.

These are mere contracts that derive their value from an underlying stock, index, commodity or currency.

Since there is no limit or check on the number of such contracts that can be issued, their numbers surge in periods of speculative excesses, causing widespread losses.

A cover for stocks

Though they may be used for speculation, derivatives are not mere speculative tools. These instruments can come in handy in protecting you from losses resulting from sudden or unforeseen price movements in your assets.   Equity futures and options are ubiquitous and the most popular. You can hedge the risk in your equity portfolio by selling Nifty futures or buying Nifty put options. The price decline in your underlying stock portfolio can be compensated by the profit made on these instruments.

It is better to hedge equity risk through derivatives on the Nifty, as opposed to specific stock futures and options.

This is because derivatives are available for only 200 stocks and many of these stock futures and option contracts are very thinly traded. But besides equity derivatives, there are other derivatives options that you might like to keep in mind.

Shielding bond investments

The Reserve Bank of India has been trying to provide investors with an effective instrument to hedge interest rate risk for many years now. But interest rate futures in their previous avatars were badly designed and did not really take off.

Interest rate futures (IRFs) were overhauled and were re-launched in January 2014 and are since generating considerable interest. Currently, IRFs are available on the 10-year Government of India security and 91-day treasury bills.

You can buy these instruments through your broker. It is the future on 10-year G-secs that would be of use to those wishing to hedge the interest rate risk on a long-term loan, for example.

Each contract of this IRF represents 2,000 units and the value of each contract is derived by multiplying the traded value of the bonds by 2,000. You have to pay a fraction of this value, generally less than 3 per cent as initial margin to your broker. At expiry, you can choose to roll-over the position to the next month or you can square the position.

You can use these instruments to hedge interest rate risk, depending on your expectation on the direction of interest rates. For instance, assume that you hold government and corporate bonds (either directly or through a mutual fund).

If you think that policy rates are headed higher, that can make your bond holding decline in value. You should then sell IRF futures. Your position will gain in value as bond yields increase; thus neutralising your loss. These instruments are also handy if you want to make money betting on interest rate movement. Those of you who want to bet on rates moving lower can buy IRFs and if you think rates are heading higher, you can sell these instruments. These instruments, however, are very risky, as a sudden sharp movement in bond prices can result in losses. Also, despite the initial outgo being small, you have to fork out Mark-to-Market amounts daily if the movement of the rates is not in your favour.

Hedging forex fluctuations

Similarly, if you are about to receive some money from overseas or have to make a payment overseas, the fluctuation of the rupee could have you in a flutter.

If the sum is material, you can hedge the risk from foreign currency movement through currency futures and options traded on Indian exchanges.

Currently, currency futures on four currency pairs dollar-rupee, pound-rupee, euro-rupee and yen-rupee are available. Currency options are available only on the dollar-rupee pair.

Again, if you are game for some risk and want to bet on the movement of the rupee, these futures or options can be used.

Making such bets through options is preferred, since the outlay is much lower and the loss is limited to the premium paid.

(This article was published on February 22, 2015)