Derivatives: Forwards vs Futures

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  Before understanding what is derivative, let’s learn what is underlying asset. Underlying asset: Underlying asset can be real asset such as commodities, gold etc or financial assets such as index, interest rates etc. Derivatives: ·         These are financial instruments who value depend upon or is derived from some underlying asset. ·         A derivative does not have its own physical existence, it emerges out of contract between the buyer and seller of derivative instrument. ·         Its value depends upon the value of underlying asset. Hence returns from derivative instruments are linked to returns from underlying assets. ·         The most common underlying assets are stocks, bonds, commodities, market indices and currencies. ·         Derivatives are mainly used to control risks. They can be used to reduce risks (a process known as hedging) or to increase risks in order to enhance returns (speculation)   Classification of Derivatives: ·         Broadly we c

Brief Overview on different types of Investments

 

In a financial markets, Assets and Liabilities valuation is important especially where the business is long term in nature.

Actuary work majorly revolves around estimation of liabilities. But there are various measures through which you can value your assets. But today we will discuss what are the different types of investments in which a company can invest in.

 

Money Market

·         Short term instrument

·         Usually preferred by the investor who needs liquidity in there portfolio

·         Returns are stable but very low

·         It is usually a favourable investment when investors are expecting a devaluation of their country’s currency. For ex, you are from India and currently 1$ = 65Rs. now you invest 100$ (i.e. Rs. 6500) in USA and you are expecting a depreciation of INR with respect to USD suppose 1$ = 70Rs. Then the value of investment will be Rs.7000 (i.e. 70*100$).

·         Expected weakening of domestic currency will make investment in overseas money market instruments attractive.

Bonds

·         First of all you should know that there are various types of bonds for ex:

o   Corporate bonds – issued by companies

o   Government bonds – Issued by Government (usually risk free if country is developed)

o   Index linked bonds – where returns are linked with an index

o   Conventional bonds – these are fixed interest bonds

o   Callable bonds - Callable bonds are those which can be repaid by borrower at any time.

o   Puttable bonds – are those where investor can demand repayment at any time

·         Insurance companies most favourite investment usually is bonds. For ex, X is an insurance company that pays out annuity to policyholders say for 10 years for Rs. 1,00,000 each per annum. Then Insurer will try to buy bonds that will provide coupon amount of atleast Rs. 1,00,000 + Expenses cost + Expected profit per annum say for 10 years. That’s how company match there liabilities outgo with assets income.

·         Yields are more than money market instruments but risk attached is also more such as:

o   Default risk – what if issuer default on the coupon or/and redemption payment

o   Liquidity risk – not easily convertible into cash at a certain rate

o   Marketability risk – not able to buy /sell easily

·         These can be available for short, medium and long term. Risks inherent in government bonds are low as compared to corporate bonds

Equities

·         Now these are more risky as compare to bonds.

·         You can make a lot of diversification in terms of equities such as:

o   On the basis of different equity industries such as in Bank stocks, Pharma stocks

o   On the basis of different companies within same industry. For ex, HDFC bank , AXIS bank etc.

o   Overseas equities

·         They provide real return and this asset is long term in nature. Technically term of this asset class is perpetuity in nature.

Property

·         Now property investment can be direct as well as indirect. For ex, you purchased a house and you want to sell it in future, then its’s a direct investment. Indirect property investment can be such as you invested in a stock that deals in property business such as DLF or any real estate company.

·         With respect to direct property there are a lot of risks such as:

o   Risk of voids (i.e. you have used that property for tenancy and there is no tenant)

o   Risks of political interference

o   Risk of obsolescence and need for refurbishments

o   Security will depend on the quality of tenant

·         Investor expects higher return to compensate for lower marketability

·         Capital values are more volatile in long term and stable in short term.

·         Each property is unique, it makes it harder to value

·         Rental yields are often lower than bond yields due to prospect of capital gain


Collective Investment Schemes

·         Loosely speaking!! It’s a mutual fund

·         Collective investment schemes provide structures for management of investments on a grouped basis.

·         There are a lot of advantages especially for an investor who does not have enough knowledge of investments or who does not have enough time to track there portfolio

Derivative

·         Highly risky investment but there are 2 major uses of derivatives i.e.

o   Hedging – to reduce the risk. For ex, I am concerned about the decrease in the value of my equity portfolio so I will cover my downside risk by purchasing a put option

o   Speculation – to enhance returns but it comes with a more risk

·         Various types of derivatives are:

o   Options

o   Futures

o   Forwards

o   Swaps (Interesting instrument used to cover the longevity risk is Longevity swaps)

Overseas Investments

·         It is not a specific type but it helps in diversification and some major uses.

·         Suppose your liabilities are denominated in overseas currency, then its better to invest in same currency to match your liabilities with your assets

·         Sometimes foreign currency market is inefficient then investor can expect higher return by exploiting inefficiencies.

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