Uses of Derivatives – Hedging, Speculation, Arbitrage
Derivatives are tools. A hammer can be used to build a house (Hedging) or break a window (Speculation).
1. The Three Purposes
A. Hedging (Risk Reduction)
- User: Farmers, Exporters, Companies.
- Goal: To reduce or eliminate risk.
- Example: An airline buys Oil Futures to protect against rising fuel prices. If oil price rises, profit from Futures offsets the loss in business.
B. Speculation (Risk Taking)
- User: Traders (Bulls and Bears).
- Goal: To make Profit from price movement.
- Example: I think Nifty will rise. I buy Nifty Futures. If it rises, I make huge money (Leverage). If it falls, I lose.
C. Arbitrage (Risk Free Profit)
- User: Arbitrageurs (Smart Traders).
- Goal: To profit from price difference between two markets.
- Example: Buy Gold in Spot Market @ 50,000. Sell Gold Futures @ 51,000. Risk-free profit of 1,000.
2. Comparison: The 3 Players
| Feature | Hedger | Speculator | Arbitrageur |
|---|---|---|---|
| Risk Attitude | Risk Averse (Hates Risk) | Risk Lover (Loves Risk) | Risk Neutral (Seeks specific opportunity) |
| Objective | Safety / Insurance | Super Profit | Risk-less Profit |
| Market Role | Transfers risk | Accepts risk | Corrects pricing errors |
3. Exam Notes: Writing the Answer
Question: "Explain the participants in the Derivatives Market." (10 Marks)
Answering Strategy:
- Headings: Use Hedgers, Speculators, Arbitrageurs as main headings.
- Motive: Clearly state the motive (Safety vs Profit vs Correction).
- Inter-dependence: Explain that "Hedgers need Speculators". If everyone hedges, who will take the risk? Speculators provide liquidity.
Summary
- Ecosystem: A market needs all three.
- Without Hedgers, market has no purpose.
- Without Speculators, market has no liquidity.
- Without Arbitrageurs, market has wrong prices.
Quiz Time! 🎯
Loading quiz…