Many investors consider equity and derivatives as somewhat similar. Yet, as we will discuss in this blog post, they differ on various counts.
Understanding equity and derivatives
To choose the right investment vehicle, we should properly understand each of these instruments.
Definition and characteristics of equity
What are equity investments? The investments transfer a part of the company ownership to the entity that holds the instrument. The value of equity is set by the share price or value set by investors or valuation experts. Companies list their shares on stock exchanges to raise money from the public to expand their business. Moreover, it benefits companies because they don’t have to pay any interest to the public.
Definition and characteristics of derivatives
What are derivatives? Derivatives are financial contracts whose values depend on underlying assets, or a group of assets, or a benchmark. Some derivatives also derive their value from equity, such as stocks and shares. They’re set between two or more parties, are usually leveraged instruments, and can be traded over the counter or on an exchange. Common derivatives include swaps, options, forwards, and futures contracts.
Similarities and differences between equity and derivatives
The main similarity between equity and derivatives is that both can be sold and purchased, and there are active markets for such trades. The main difference between equities and derivatives is that the former derives its value from market conditions such as political, economic, and company-related events and supply and demand. Meanwhile, derivatives derive value from other financial instruments such as currencies, commodities, bonds, etc.
Analyzing the risks and returns of equity and derivatives
No investment is entirely risk-free. A prudent approach would be to choose the less risky one.
Risks associated with equity investment
Equity investments involve risks. Market forces impact equity investments directly. It also carries credit risk where companies can’t pay their debt. Another factor is foreign currency risk, where fluctuation in exchange rates could affect equity value, and liquidity risk, where companies can’t meet their short-term debts. Political risks stem from geopolitical issues, while rising inflation can depress equity prices.
Return on equity
Return on equity (ROE), which gauges a company’s profitability, is the net income divided by shareholders’ equity. The higher the ROE, the better a business is at converting its equity into profits. ROEs will differ based on the sector or industry in which the company operates.
Risks associated with derivatives investment
Derivatives carry market risk, the general overall risk any investment faces. Besides that, there’s also counterparty risk when the dealer/seller/buyer defaults on the contract. There’s also liquidity risk, which applies to investors who plan to close the derivative trade out before maturity. Finally, there’s the interconnection risk, which is how the interconnections between derivative dealers and instruments affect investors’ specific derivative trades.
Returns on derivatives investment
Using derivates, one can hedge against unfavorable rate movements through locked-in prices. A wheat farmer is worried that the wheat price will be lower than his production cost (say ₹7,000/ton) when the crop is ready for delivery. He can either enter into a forward derivative contract with someone who agrees to buy the crop at ₹10,000/ton in 3 months, or he could wait till the crop is ready and then sell for a profit/loss. The farmer benefits from the derivative contract if the wheat sale price goes down to ₹7,000/ton. Conversely, if the wheat price goes up to ₹11,000/ton, then he makes a loss.
Basically, derivatives help consumers and producers reduce the risk of losing money due to price fluctuations. The risk is, instead, passed onto the trader/speculator.
Choosing the right investment strategy
Choosing the right investment strategy is crucial as it has a bearing on your returns.
Factors to consider when choosing between equity and derivatives
The investment objective is an important aspect to consider when choosing between equity and derivatives. While equity stocks are not time-sensitive, derivatives come with expiry dates. In other words, equity investments work for everyone as one can hold onto equities until investment objectives are fulfilled. Derivatives, however, are better for those with extensive experience in the capital markets.
How to create a balanced portfolio with equity and derivatives
Having equity and derivatives in your portfolio is like feng shui for your investments—one works when the other doesn’t. One effective strategy to build a balanced portfolio is to split your share portfolio across various sectors. In addition, you should balance high-risk-high-return companies with lower-risk ones like blue chips. Finally, if you’re a beginner, an effective strategy is to invest in index funds. Here’s a useful guide on how to use index funds for diversification.
The impact of market conditions on equity and derivatives
Corporate results, interest rates, and economic data impact equity and derivatives. The outlook, margins, sales, and profits of businesses have a massive impact on equity demand and influence the derivatives’ underlying assets. Besides, fluctuations in interest rates lead to decreased/increased demand for equity stocks. Finally, positive economic data create equity demand and affects the dependent derivatives contracts as well.
The role of an investment advisor in equity vs. derivatives decision-making
When you’re unfamiliar with financial aspects and investment techniques, it’s advisable to hire investment advisors. They are well-versed in everything financial and would help you build a well-balanced portfolio in accordance with your financial goals. Moreover, they also monitor the market and individual portfolios and make necessary adjustments. Finally, they give you alerts about avoiding making financial errors, thus safeguarding your assets.
Whether you invest in equity, derivatives, or both, your portfolio must be in sync with your financial objectives and risk profile. Choosing the right investment will help you profit from the market in the long run.