Equity Derivatives – Meaning, Benefits and Types

Derivatives are financial instruments or contracts whose values are derived from underlying assets. These assets can be almost anything. Trading in derivatives existed in India for over a hundred years. However, it was primarily unorganised. An organised effort only began in the 1990s with the L.C. Gupta Committee. The recommendations formed the basis of the Derivatives trade in India. Equity-based derivatives trade started only in 2001, with Commodities Derivatives and Currency Derivatives following in 2003 and 2008, respectively. Since then, the work in Derivatives has come to represent a rapidly growing significant section of the economy.

Additional read: How to Manage Risk While Trading in Derivatives

Definition of Equity Derivatives

Derivatives are financial instruments whose value is derived from underlying assets. The major types of derivatives are Equity Derivatives, Commodity Derivatives, Interest rate Derivatives, Currency Derivatives and Credit Derivatives.

Equity Derivatives refer to a class of Derivatives whose underlying value is determined by the price movements of one or more underlying equity assets. Equity Derivatives are contracts between two parties in which they agree to sell or buy the underlying asset in the future at a set price.

Benefits of Equity Derivatives

• Investment in Equity Derivatives is tied to the underlying asset's performance and not the ownership of the asset itself. Thus, the risk of financial loss is less in Equity Derivatives.
• Equity Derivatives give better returns in the short term. Investors can thus profit on idle shares.
• Investment in Equity Derivatives helps mitigate risks associated with price fluctuations of the underlying assets.

Types of Equity Derivatives

Equity Derivatives can broadly be classified into the following:

• Equity Options provide traders with the right to buy or sell the underlying asset, but they are not legally obligated to do so. Equity Options are the most common type of Equity Derivatives with one or more underlying securities. These are best suited for risk-averse investors.
• Warrants are derivative instruments that give the trader the right to buy, but not an obligation, shares or stocks of a company at a predetermined price before the expiry of the contract. In the case of warrants, the underlying instruments are generally preferred stocks and bonds to enhance their value to potential buyers by companies.
• Convertible bonds allow traders to convert them into stock shares of the issuing company. Convertible bonds act as hybrid security, allowing traders to benefit from equity returns while protecting themselves.
• Futures are contracts where a trader agrees to buy the underlying asset at a given date in the future for a fixed price and is legally obligated to do so. Futures can either be Single Stock Futures, Basket Shares Futures and Index Futures.
• Forwards are contracts, similar to Futures, where the buyer agrees to buy the underlying asset at a given date for a fixed price and is legally obligated to do so. However, Forwards are traded only on Over Counter (OTC) markets.
• Swaps refer to bilateral contracts where the parties agree to exchange the returns from two different equity stocks for a fixed amount of time. Equity Swaps allow investors to reap tax benefits and diversify their portfolios.

Conclusion

Equity Derivatives thus represent an emerging category of Derivatives trade that offer more significant short-term benefits. The Equity Derivatives trade in India has grown steadily over the past two decades, showcasing the growing interest of the investor community in equity derivatives.

Equity Derivatives requires in-depth knowledge of finance. That can deter some. However, those who persist in their endeavour may benefit from their greater knowledge and become better and responsible investors.