Finance during the pandemic: Understanding some basic instruments

Financial markets have taken a tumultuous turn since the invasion of COVID-19, with major world economies going haywire and any algorithm to predict the volatility and returns of any financial instruments being rendered moot, since no algorithm could predict the current downturn the markets have taken. Common investors, who used to park some portion of their savings in financial instruments in hope of appreciable returns have their prerogatives shifted to exit their equities positions and instead go for passive instruments such as bonds or Exchange Traded Funds (ETFs). Some astute investors have also shifted to investing in future contracts and options, while others have prioritised tackling this volatile situation by investing in insurance. Yet again, some have shifted to investing in global financial markets as their last resort. Any novice in the investors’ battlefield may either not be aware of the aforementioned technicalities or may not have any prior experience of investing in these instruments. So let’s embark on our journey to get a fair idea of what these instruments are and how can they prevent you from plunging into risk during and after this pandemic?

Bonds

A fixed income instrument wherein you invest a lump sum into a certain project and are entitled to fixed periodic payments. You are regarded as a creditor or debt holder of that particular project, and your stream of income remains fixed irrespective of the status and the revenue generation of the project. On very basic terms, it is very similar to you taking a loan from the bank. In that case, the bank is the creditor who has invested a lump sum on you, and is entitled to periodic payments as mentioned in the loan’s terms and conditions. Since bonds (and other debt instruments) offer a minimal risk, they are generally among the lowest bracket in terms of returns.

Exchange Traded Funds (ETFs)

An Exchange-Traded Fund is a pool of various debt and equity securities, which closely tracks an underlying index or a commodity. It is christened “Exchange-Traded”, because it trades on a common stock exchange just like everyday stocks, and is subject to intraday shocks similar to stocks. ETFs probably are the most sureshot mechanism to diversify your portfolio and thus minimize your risk. The portfolio of an ETF contains varied financial securities for various risk classes, and offer much lower risk than general stocks do.

Future contracts and Options

Future contracts or “futures” in short is a drawn-out legal agreement between two parties regarding the purchase/sale of some particular underlying commodity in the future at a predetermined price, as mentioned in the contract. The parties involved in the contract are obliged to see the contract through, or they may be subjected to legal actions. An option, on the other hand, is a financial instrument similar to a future contract minus the element of obligation. In case of an option, it entirely depends upon you whether to exercise the option or not. Let’s quote a simple example. Imagine you are a textile merchant. You have drawn out a futures contract with a customer that you will deliver 75 Kgs of cotton one year later at a price of INR 30 per Kg. This contract was drawn by you in order to hedge yourself against the volatility you observed in the price of cotton. Now, you are obliged to deliver the aforementioned quantity of Cotton at the aforementioned price, regardless of the movement in the price of cotton. If the spot price (current price) of cotton after 1 year is INR 40, you have suffered a loss, while if the spot price after 1 year is INR 20, you have gained immensely. By now, you may have already achieved an idea of how the equations would have changed if you instead had bought an option. You now are not obliged to deliver the quantity of cotton. Instead, you can closely track the prices of cotton, and reach a decision on your own accord whether you should exercise the option or instead sell it in the open market.

Insurance

As the name suggests, insurance is a mechanism to shield you in any high-pressure risk situation. In order to exercise any particular type of insurance, you need to buy out an insurance policy and pay periodic premiums, so that in case of any insecure circumstances in the future, you may be covered under the insurance policy accordingly. Different types of policies exist to insure you against different types of situations which include life insurance, motor insurance, health insurance etc.

In the next article in this series, we try to venture into the macroeconomic aspects of the pandemic, and later decipher how these instruments can be employed to maximize your returns with optimum risk while the pandemic persists, while also further traversing to how you can exploit offshore securities and global financial markets. Till then, Au Revoir !!!