Financial derivatives

1. Few Basics
On Markets, Longs, Shorts,
Risk
Speculator, Hedger, Arbitrageur

2. Risk, Speculator, Hedging
• Speculative Risk can result in Both Profits or Losses
• One who takes Speculative Risk is called Speculator
• Speculator Takes Risk
• Hedging mitigates Speculative Risk
• One who mitigates risk or want to mitigate Risk is called Hedger
• Hedger Mitigates Risk
• Hedgers Objective is not to make speculative profit or losses, but ensure
certainty of Cashflows
If you are Not Hedging (Hedger), Then you are a Speculating (speculator)

3. Theory Vs Practice and
• First Understand the theory later we will see if it is practically
possible.
• You will always find that many of theoretical concepts are not
practically possible.
• However, Understanding Theory is Important.

4. Spot Market
• Spot market or Cash Market (Spot for Short) is a market where goods
are exchanged immediately for cash.
• Example: Vegetable Market, Gold Shop, Metro cash and carry etc.,

5. Short Selling
• Theoretically to make money from Falling markets, one needs to sell shares
first and then buy shares later to make money
• Is it practically Possible?
• How do you do Short Selling in Spot Market?-
• Selling something you may not have?
• You can only do it if you can borrow shares.
• Short Selling can be done provided you can borrow the underlying asset.

6. The Long and Short of It ( In Spot Market)
• Buy is Long and Sell is Short
• Short Sell is selling something you don’t have.
• In the spot market it can only happen when you borrow the physical asset form someone else.
• In trading (or investing) there are only two things one can do, Buy or Sell (long or Short)
• For Companies, Receivables is Long, and Payables is Short
• If you own some thing (assets) or expected to receive some thing you are said to be long on that something.
• If you have an obligation (liabilities) to pay some thing or need to return something at a later date, then you
are said to be short on that something.
• For Ex: A gold mining company engages in Sale of Gold as part of the business. It is long on Gold
• For Ex: An Airline Company Engages in Purchase of Oil as part of its business. It is short on Oil
• When you have a Long or Short Position in the market, you are said to be exposed to Speculative Risk.

7. Squaring Off
• If you buy 100 shares of Infosys as your first trade. Then you are said to
have a Long position in the Market.
• The Position is Long
• If you sell 100 shares of Infosys (after buying 100 shares some time before). Then you
are said to have “squared off” your position.
• Now you have No(zero) Position on Infosys.
• When you have no position in Infosys.
• You have no risk to price fluctuations of Infosys.
• If you Short sell 100 shares of Infosys as your first trade. Then you are said to have a
Short Position in the Infosys Stock
• The Position is short.
• To “SQUARE OFF” or “Close” the short position you need to go long

8. Arbitrage
• Arbitrage means dealing simultaneously (going long and
Short) in multiple markets, to exploit a temporary
discrepancy in prices, and earn a risk-free profit.
• Notice the arbitrage opportunity is both (i) temporary and (ii)
risk-free.
• Is it Practically Possible ?
• Understand the Theory !!!

9. Summary (Types of Traders)
• Speculators (Take or want to take speculative Risks)
• Hedgers (Exposed to Speculative Risk- want to mitigate the same)
• Arbitragers (Want to take profit (or Make Money) without Taking Risks)
• Arbitragers being smart would enter the trade only when they see an opportunity to make money and would
never do a trade otherwise.
• Speculators
• (Have a Long or Short Position and would have taken it with the intention of making Speculative profits–
however it may result in loss also)
• Hedgers
• (Have a Long or Short Position by the nature of business or taken theses positions in the past and would now
want to mitigate that Risk)
• Arbitragers
• Take Simultaneous long and short positions in two different markets to exploit the difference and make risk
less profit.

10. Check your understanding
• Why does anybody hedge?
• What is the benefit or outcome of Hedge ?
• Wrong Questions
• Where is the profit in the Hedge?
• I am a speculator who wants to hedge to make profit?
• Why is he hedging?