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Understanding Derivatives in a Simply simply way

Understanding Derivatives the Simply Simple way.

1) There is a shopkeeper Ramlal selling Maggi.

2) Seema loves her Maggi & daily visits the shop to buy her packet of Maggi for Rs 10.

3) She is obviously very money conscious.

4) One day while gossiping with her friend Subhash, she is informed that price of Maggi may go up substantially in the next one year.

5) Next day she tells Ramlal that she would would promise to pay next years Maggi supply of 100 packs at the rate of Rs 12.

6) Ramlal thinks to himself that the idea is not bad at all because be can ensure himself a profit of an additional Rs.200.

7) So he provides her coupons of Maggi which she can use next year.

8) Seema pays Rs 100 x 12 = Rs 1200 and goes home.

9) But as Ramlal is walking home he thinks to himself that in case Maggi prices go beyond Rs 12 after a year then he would incur a loss.

10) But being a super intelligent man he gets an idea to protect his interest.

11) He decides to buy 100 packets Maggi for Rs 10 today for Seema and store it in his shop.

12) One year passes by and Maggi prices do go up as Seema had anticipated.

13) The price which was Rs 10 a year ago now is Rs 14.

14) Seema is very upbeat as she enters Ramlal’s shop with her coupons.

15) She expects Ramlal to be in a foul mood as he would be losing Rs 2 (Rs 14 – Rs 12) × 100 = Rs 200

16) But to her astonishment, Ramlal is seen smiling which Seema cannot understand.

17) When Seema asks for her order, he instructs his employee to go to the store room behind the shop and get the 100 packs of Maggi purchased a year ago on her behalf Seema.

18) Thus Seema leaves happily thinking that she has made a clean Rs 200 (Rs 2 per packet × 100 packets ) profit.

19) Ramlal on the other hand also smiles because the 100 packs he sold Seema were purchased by him for Rs 10 one year ago which he sold for Rs 12. Thus he too made a clean profit of Rs 200 (Rs 2 × 100 packs of Maggi)

20)This situation clearly ended in a win win manner and left both Ramlal and Seema happy.

The key learnings from this story are as under :-

1) The above example explains the principle on which Arbitrage Funds work. In this example Ramlal is the Arbitrage Fund. As Ramlal safeguarded his interest and ensured that he will not be at a loss in the same way Arbitrage funds are very safe.

2)This example also explains the meaning of Derivative Instrument. The coupons which represented 200 future Maggi packs represent what we call as derivative instruments because it’s value is derived from the value of the underlying Maggi packs

3) This example also explains how derivative instruments can be used as a hedging tool. Althought Ramlal sold 200 packs of Maggi for a future date by way of giving Seema the coupons, he hedged himself by buying 200 packs Maggi and storing the same for future use.

4) What Ramlal did was he sold a future product without owning it. We call this kind of selling as “going short”. Instead of selling product he sold the coupons which over here represent a derivative instrument.

5) However one must appreciate although he sold without owning the product it was his obligation to honor his word. He had two choices.

a) One was to purchase from the current market at Rs 14 and supply it to Seema at Rs 12. This kind of a situation is called as “Naked position” where your losses are not hedged or protected.

b) The second option was to hedge his position by buying 200 packs of Maggi and storing it for Seema at the same time he sold the Coupons (Derivative Instrument). Your short stands covered when you hedge and this is called short covering.

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