What is a Derivative in Mutual Funds

Derivatives are financial instruments that are contracts or agreements, the value of which is tied to an underlying asset, index, or any other financial instrument.

There are some mutual funds that potentially use investment techniques dealing with derivatives and derivative instruments. Derivatives are considered important to investors as they potentially hedge risk and allow you to manage it. For instance, derivatives are commonly used to mitigate risks generated by interest rates. If you are investing in mutual funds, or planning any other investments, it is important for you to learn about the role that derivatives play. In this article, we will explore what derivatives are, the different types of derivatives, and their uses.

Once you have answered the question, “What are derivatives?”, you will understand that derivative contracts are related to a number of investments or assets such as stocks, commodities, currency, and other securities in mutual funds. When mutual funds involve the use of derivatives, they act as a strategy for investment.

If you are investing in mutual funds and wish to know how you can make use of the derivative advantage, it is important to grasp some key aspects of derivatives.

Mutual funds are permitted to use derivatives for the purpose of hedging by the Securities and Exchange Board of India (SEBI). Typically, derivatives are employed by mutual funds to hedge any given fund’s equity assets. Additionally, derivative strategies may be used by mutual funds in their arbitrage operations and for speculative reasons. Where speculation is concerned, derivatives are often used to make estimations of the investment’s performance according to the price movement of the underlying asset. Generally speaking, when you wish to understand derivatives’ meaning, you should know that derivatives provide you with leverage in your investment.

• Derivatives are financial contracts between two or more parties whose value is linked to an underlying asset, a group of assets, or a benchmark.
• These contracts can be traded on recognised exchanges or through over-the-counter (OTC) markets.
• The value of a derivative changes based on movements in the price of the underlying asset.
• Derivatives are generally leveraged instruments, meaning a small investment can result in higher potential gains or losses.
• Investors and businesses often use derivatives for hedging risks, managing exposure, or seeking investment opportunities.
• Common types of derivatives include futures contracts, forward contracts, options, and swaps.

By now you may have understood what a derivative in mutual funds entails. It is time to explore the types of derivatives that can be used. They are explained below:

Forwards

When two parties enter into an agreement (say, when one party wishes to sell a commodity and the other party wishes to buy it), at a date in the future and at a pre-fixed price, the transaction entered into is a forward contract. Such an agreement/contract is customised to a particular transaction and cannot be used by another party (that is, the contract cannot be listed on a stock exchange or traded).

In forwards or forward contracts, you may be able to understand a forward derivative’s meaning better with an example: Assume that you are a farmer and plan to grow 1000 kilos of rice next year. You have the option to sell your rice at the applicable price when it is harvested, or fix a current selling price by way of selling a forward contract. If you choose the latter, the contract obligates you to sell your 1000 kilos of rice, at a predefined price to a purchaser after the rice harvest. Basically, you are locking in the selling price of 1000 kilos of rice and preventing the risk of decline in the price of rice. In case the price of rice increases from the fixed price you have set by the forward contract, you will still have to sell at the price determined by the contract.

Futures

You may have understood the answer to the question, “What is a derivative?”, but it is crucial that you know another type of derivative contract that is commonly used in investment. This is a futures contract. Broadly speaking, a future is a contract or an agreement that involves two parties, a buyer and a seller, just like the forward contract. However, whereas a forward contract is customisable, a futures contract is standardised.

A futures contract is one in which a seller is obligated to sell, or a buyer is obligated to buy, an underlying asset or security at a predefined price at a future date. Such contracts, as they are standardised, may be traded on stock exchanges. Let’s have a look at the example below:

Say, you purchase an oil future on 1 August 2024, at a fixed price of Rs. 10,000, and pay a margin of 5% (Rs. 500). Now assume that the oil future gains in value and becomes Rs. 11,000 by 1 October 2024. Your gain is Rs. 500 (Rs. 11,000 less Rs. 10,000, less Rs. 500). Your initial investment was Rs. 500 (the margin), and your return is Rs. 500 (100% return), from August to October. Imagine if the price of oil had dropped, the oil futures contract would have also corrected proportionately and you would have faced a loss.

Futures contracts may be used in the investing of mutual fund schemes as a way to hedge risks and manage funds to mitigate loss.

Options

An options contract is just like a futures contract, except that there is no obligation to execute the contract by a predetermined date and a fixed price. So, in an options contract, the buyer or seller can buy or sell an underlying asset or security at a pre-fixed price (strike price) on or before a pre-decided date (expiry date). However, the parties are under no obligation to execute it and can opt out. Nonetheless, to enter an options contract, a premium must be paid, and if a party opts out, the premium has to be paid.

In terms of derivative mutual funds, options contracts have underlying equity-based securities like shares of stock. If you are investing in mutual funds, you should know about options contracts and their types. Typically, there are two kinds of options contracts, depending on the buying and selling of underlying assets/securities defined in contracts.

It follows from this that if a buyer expects that the price of an underlying asset or security will increase, they can buy a call option, giving the buyer the right, but not the obligation, to buy the underlying asset/security at a fixed price on a predetermined date. in contrast, if the price of the underlying asset or security increases, the buyer executes their option and books their profit. In case the buyer estimates that the price of the underlying asset will drop, they let the contract lapse without executing it. As you can tell, mutual funds and derivatives contracts let fund managers get the most out of funds by controlling loss.

In the case of a put option, a buyer may estimate the value of an underlying asset/security of an options contract to drop. The buyer then executes a put option that gives the buyer the right but not the obligation to sell the security at a fixed price on a predetermined date. If the price of the underlying asset or security declines, the buyer executes the put option and books a profit. In case the price does not move or moves up, the buyer does not have to exercise the options contract and lets it lapse.

Broadly speaking, derivatives are used for three distinct purposes and these are explained below:

Hedging

The way that derivatives are used as a strategy for hedging in mutual funds explains derivatives’ meaning as it applies to mutual funds. This can be understood with a simple example: Let us say a fund comprises the stock of a company. The price is expected to decrease, but only on a temporary basis. If the fund continues to hold the stock, the drop in the price will impact the performance of the fund temporarily. The fund can safeguard itself by selling a futures contract of the said stock, hedging the drop in the price of the stock. Once the price drops, the futures contract is sold, delivering a profit that is equal to the temporary loss generated by the company stock.

Speculation

Derivative mutual funds are often those that use derivatives as a strategy to speculate about bullish or bearish markets, and hence, the performance of an asset, usually a stock. You can easily speculate by using derivatives taking bearish or bullish positions relating to the underlying security through futures and options contracts rather than direct buying and selling actions. For instance, you may not hold a stock but may still predict that its price is going to drop. You can sell a future contract of the stock or you can buy the put option. When the price drops, you can easily square your position, making a profit. As an investment through a margin or premium is lower than buying or selling an underlying security, the profit is high, but so is the loss.

Arbitrage

It is also possible to use derivatives to make the most of market inefficiencies. You can do this by taking advantage of differential prices between markets. For instance, a stock of a particular company may be valued at Rs. 20 on the Bombay Stock Exchange (BSE) and valued at Rs. 21 on the National Stock Exchange (NSE) on the same day and at the same time. You can buy the stock on the BSE and sell it for a profit on the NSE. Such an exercise is known as arbitrage and can be done through futures or options contracts by predicting price changes and deciding predetermined values by certain dates of expiry.

There are lower transaction costs
Trading in derivatives generally involves lower transaction costs compared to other securities, such as stocks and bonds. Since derivatives are mainly used for risk management, they provide a cost-effective way for investors to manage their market exposure while keeping transaction expenses relatively low.

Hedging risks
Hedging is a strategy used to reduce the risk associated with an investment by taking an offsetting position in another financial instrument. Derivatives are widely used for hedging because they help protect investments from unfavourable market movements.

Risk management
Derivatives act as a form of financial protection by helping investors manage and reduce potential losses. They are commonly used to minimise market risk and provide greater stability in an investment portfolio during periods of market volatility.

Mutual funds make the use of certain investment techniques dealing with derivatives. Derivatives are financial instruments that are agreements or contracts, the value of which is linked with an underlying security/asset, instrument, or index. Commonly, derivatives play an effective role in hedging and/or managing risk in mutual funds. For instance, derivatives are among the most popular instruments for hedging risks generated by interest rates.

Derivatives’ meaning is clear when you know how they are used, especially to mitigate risks while investing in mutual funds and making your investment potentially profitable. Derivatives can be used to speculate on investments based on the price movements of an underlying asset, to get exposure to an area that is difficult to invest in directly, or generate optionability where the value of the derivative is related to a specific event or condition. Derivatives generally produce leverage. As a result, any small shift in the underlying asset's value can cause a large difference in the derivative’s value and result in huge profits or losses depending on the direction of the change.

While speaking about mutual funds and derivatives, you should note that examples of derivatives include futures, options, forward currency contracts, and options on future contracts.

While derivatives are used to hedge risk, they are also subject to interest rate risk, liquidity risk, market risk, management risk, and credit risk. Additionally, derivative instruments may face dramatic changes in price and faulty correlations between the price of the derivative contract and the underlying asset, security, or index, increasing the volatility of a mutual fund. Derivatives and forward-settling assets and securities also factor in leverage risk because they are able to provide investment exposure of an amount higher than the initial investment.

After you have learned about derivatives’ meaning, you should note that there is no assurance that a mutual fund's use of any derivative strategy will necessarily be successful. A mutual fund's management may employ a proficient risk management process to supervise and manage derivative exposures in a fund, but the use of derivatives may entail risks that are different from, and, in certain cases, higher than, the risks that are presented by the securities or assets from which they are derived. Hence, even if investors know the answer to the question, “What are derivatives?” sufficiently well, they must carefully consider their risk tolerance and financial goals and circumstances before investing in mutual funds that use derivatives.

Some mutual funds may use derivative instruments on a limited basis, while others employ them as a central strategy. A fund's prospectus can provide you with a summary and a detailed description of the fund's investment strategies, and its Statement of Additional Information offers additional details about it. You may find it helpful to visit a mutual fund company's website as it will often give you useful commentary as well as insights into how a specific fund is managed.

Mutual funds and derivatives work well in the mutual fund investment domain, providing ways to hedge risks and speculate on price movements of securities to earn potential profits for investors. Once you know the concept of derivatives and all that they entail, you can grasp how they may make a fund lucrative and how fund managers use them to manage funds efficiently.

However, before you invest in mutual funds, it is important to consider your unique investment goals and financial position, not to mention your risk tolerance. You can choose a fund that is a suitable match for your distinct requirements on the Bajaj Finserv Mutual Fund Platform, giving you a plethora of different mutual funds (more than 1000) to compare and select. Making an appropriate choice on this intuitive platform is easy and you can use online calculators to estimate returns as well as make initial investment decisions.