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.
