Bye-bye derivatives?

In edition #19 of Better Markets Digest, we look at:

- Things that moved

- Performance review of derivatives

- MFs might buy and sell protection

Big numbers:

• State Bank of India will raise $3 billion via debt in the current financial year. In January of this year, it had already raised $600 million.
• Blinkit will receive ?300 crore from its parent, Zomato, to compete with Swiggy’s Instamart and Zepto. With this latest investment, Zomato has infused nearly Rs 2,300 crore in Blinkit since it was acquired.
• The government will assist 3 crore households for the construction of houses under the PM Awas Yojana. This news pushed the shares of housing finance and infrastructure project firms up by 9%.

RIP

Let’s say you think Reliance’s shares will go up in the next 2 months. You can buy the stock, of course. But you’ll have to commit a lot of money for that, chasing middling returns.

Well, instead, you can buy a call option — a ‘derivative contract’ that lets you bet on the price of the share alone. This lets you pocket the upside, without a really big investment.?

A ‘derivative’ is a financial contract that derives its value from an underlying asset — in this case the stock of Reliance. There are many other derivative contracts like this on the market —- letting you take bets on all sorts of different things a stock (or an index) can do. The other party to the contract, meanwhile, bets that the opposite shall happen.?

But there’s a catch.

You can’t trade derivatives for every stock. Stocks can only have derivatives if they fulfill all the conditions outlined in SEBI's checklist. This list was made in 2018. But since then, things have changed.

You see, the derivatives market in India seems to have gone up exponentially over the past couple of years. In the past four years, i.e. since COVID, lots of people have entered the market. So much so that of India accounts for 78% of the 108 billion options contracts traded in the world.

SEBI, as always, is worried about investors. Why? Well, they worry that some stocks used for derivative trading might be manipulated or become too risky. If a stock isn’t usually traded too much, anyone trading a lot of the stock can cause large price swings, in turn affecting a lot of retail investors. To prevent this, SEBI only wants to allow trading in stocks that are well-established and have a lot of activity.?

So, they are reviewing the checklist they made back in 2018. That might mean a lot of derivatives for stocks will soon go away.

Protection

Life is uncertain. That means, let’s say you are driving near Silk Board, and a car switches on the right indicator before swerving left and crashing into you. What do you do? You buy car insurance to protect yourself from very Indian happenings like this.??

Now, Zoom out a little. Let's say you are an investor and you have bought a govt bond of Namibia. Why? Well, why does anyone buy Namibian bonds? It’s not like Namibia will become the new China. The only other reason is that Namibian bond yields are high. But then again, this is Namibia we are talking about. Namibia can go bust tomorrow and not pay the bondholders.?

So, how do you protect yourself against the risk of default? In other words, what’s car insurance for countries? There’s a thing called “Credit Default Swaps.”??

Here’s how Gemini explains credit default swaps: “A Credit Default Swap (CDS) is a financial agreement that acts like insurance for a loan or bond investment. Here's a breakdown in simple terms:

Imagine you lend money to a company by buying their bond. It's like giving them an IOU that promises a return on your investment. But what if the company can't pay you back (defaults)?

A CDS acts as a safety net:

You pay a small fee (premium) regularly to another party, like a bank or insurance company.

In case of default: If the company you loaned money to can't pay you back, the CDS seller compensates you for your loss. They essentially pay you back the amount you invested in the bond.”

Here’s the news: mutual funds might soon be able to buy and sell CDS. But, why would a mutual fund do this?

Well, to hedge against risk. See, mutual funds manage people’s money, and if things go wrong, it can affect the investors. But, what if it can insure itself against that possibility? Let’s say it’s bought some bonds that might default, but someone wipes that risk away. It only needs to pay a small amount of premium, and in the event of a default, it’s safe.?

Chart of the Day:

If it’s made in China, it has to be cheap, doesn’t it? Well, maybe, not anymore.?