A derivative basically is a financial contract whose value depends on its underlying asset.
And that underlying asset could be anything like stocks/shares of a company (Equity), Govt Bonds and even commodities like gold, silver etc.
In India, the most commonly used derivatives are:
– Futures
– Options
Instead of buying or selling the asset directly, derivatives allow investors or fund managers to take certain market positions based on expected price movements.
Lets us understand this by taking an example:
Imagine that you agree today to buy gold after 3 months at a certain fixed price (higher price than todays).
So if gold prices rises , you benefit. And if prices fall you loose, and the other party benefits.
This agreement is very similar to a derivative – in this case it derives it value from the price of gold and the underlying asset here is gold itself.
So why do Derivatives exist?
Derivatives were originally created to manage uncertainty in the market, not to gamble.
Just like:
– Insurance protects us from any unexpected events.
– Fixed deposits give predictable returns.
Similarly Derivatives help market participants manage price fluctuations and volatility.
How are Derivatives used in Mutual Fund?
Mutual Fund managers in India use derivatives very differently from traders. Their goal is not to make quick profits but portfolio stability and discipline.
Here are the different ways Derivatives are used by the Fund Managers:
1. Managing Market Volatility (Hedging)
As we all know the stock market do not move in a straight line, rather regular ups and downs.
If a fund manager feels markets may fall temporarily, they may use index index derivatives (like Nifty futures or options) to:
– Reduce downside risk
– Protect the value of the portfolio
– Avoid selling good quality stocks in panic
This helps the fund stay aligned with its long-term strategy.