Derivatives are generally regarded as a very risky investment. Then why is it that the derivative funds are said to be a safe investment with low risk of capital erosion?
- Amrit Lal
The derivatives were originally launched as risk-management instruments. But it is true that if used inappropriately, they are capable of delivering huge losses to an investor. If derivatives are used for hedging purposes (which is what the mutual funds do), they become an effective tool to restrict, or even eliminate the downside of your equity investments. But if you take an unhedged position in derivatives (which is what most of the investors do), then the losses can get magnified if the markets fall.
Derivative instruments are traded in lots (each lot is called a contract) and the rupee value of each lot is Rs 2 lakh or more. And unlike shares, you are not required to pay the full amount to buy a derivative contract. You can do that simply by paying a 15-20 per cent margin. For example, at 15 per cent margin, you can buy a futures contract worth Rs 2 lakh by paying only Rs 30,000. Many investors see this as a wonderful prospect to make quick money by making little investment. To illustrate, if this futures contract appreciates by 10 per cent, the investor will earn Rs 20,000. This translates into a whopping 67 per cent returns on his actual investment of Rs 30,000. This lure of making quick money attracts a lot of knaïve investors towards derivatives. But on the contrary, if the value of futures contract drops by 10 per cent, then it can also inflict a 67 per cent loss to your investment. Therefore derivatives can become a high risk-high return proposition if you take unhedged positions in them.
But mutual funds usually use derivatives to hedge their portfolios. This means that if the markets go up, the fund's gains will be restricted, and if the markets fall, the fund will lose less. This makes such funds a low-risk low-return proposition.