The Difference Between Shares, Bonds & Derivatives is Explained

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Equirus Wealth

09 Dec 2022 6 min read

Stock Market#Stock Market#Investment

Shares, bonds, and derivatives are different asset classes with varied risk-return profiles. While you may be somewhat familiar with shares and bonds, little is written about derivatives which are considered high-risk. Stocks and bonds are also a means of raising finance for any company. However, derivatives are assets that derive their value from their underlying asset. Here we decipher the differences between the asset classes. However, before that, we need to have a thorough understanding of these assets.

What are stocks, and how do they work?

Equity shares give the holder of the instrument a portion of the ownership of the firm. There are other types of shares called preference shares which offer a fixed dividend. Their dividend payment takes priority over the dividend payment of ordinary shareholders. Ordinary or equity shares can be either public or private. If the company takes the public offer route (IPO / FPO), then the shares are traded on the exchange, where the demand-supply dynamics would determine the share price. Hence the volatility would be particularly high. Private equity is yet another way of raising capital within a select private group of investors. The volatility in private equity shares would be relatively less.  A corporation always benefits from equity since, unlike bank loans, it is not required to pay the public any interest.

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What are bonds, and how do they work?

Bonds are fixed-income securities that reflect loans made to borrowers by investors (typically corporate or governmental). A bond may be compared to an agreement outlining the terms of the loan and the associated payments between the lender and borrower. It is similar to an I.O.U between the lender and the borrower, in this case, the investor and the issuer. The issuer of the bond agrees to pay back the face value of the bond on a specific date and also promises to pay fixed (or flexible) interest rates in the form of coupons periodically, typically twice a year.

Bondholders, when compared to shareholders, are in a better spot if the business declares bankruptcy. They are paid back before shareholders since they are included in the category of creditors. In addition, there is frequently a potential for recovery even when the issuer fails on its debts, although at a lower level. There is always the possibility of credit or default risk, where the issuer fails to meet the promised coupon rate or payback of face value. Typically, the bonds issued by Government are considered to be of lower default risk.

What are derivatives, and how do they work?

Derivatives can be understood as a security with a price that is based on or derived from one or more underlying assets is referred to as a derivative. Changes in the underlying asset's value affect its value. The fundamental idea behind using derivative contracts is to make money by making predictions about how much the underlying asset will be worth in the future. It can also be used as a cushion to counter a loss that you may incur in the spot market. They are financial assets sold on stock exchanges or over-the-counter markets, in contrast to equity (OTC). While practically all equities trades take place on an exchange, derivatives deals can be carried out with or without the assistance of a stock exchange. The derivatives categories include futures, options, forwards, and swaps. The ability to purchase or sell an underlying asset (stock, index, commodity, currency, etc.) at a later time is provided by a derivative contract.

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Differences between stocks, bonds, and derivatives

Point of differenceSharesBondsDerivatives
Investment ObjectiveLong-term investment or speculative tradingSafety and fixed incomeSpeculative trading or hedging
Risk profileHigh riskLow – moderate riskVery high-risk
LiquidityHighLow – ModerateHigh
Traded onSecondary market (if listed)Secondary market (if listed)Derivatives market or OTC
TenureIdeal for medium-long termIdeal for long termShort term

Tips for beginners to invest in shares, bonds, and derivatives

While beginning your investment journey in shares, bonds, and derivatives, here are a few things that you need to remember:

  1. Bonds are a safe place to start if you are a conservative investor, it is also ideal for adding some debt exposure to your portfolio to insulate against extreme conditions in the equity / derivative markets.
  2. Government bonds are safer than corporate bonds. Bonds have ratings. Look out for AAA or AA+ ratings, which offer decent returns at lower default risk
  3. Start investing in equity shares only after a thorough understanding of the risk-return dynamics. Within equity shares, you have different categories of shares based on their market cap, which offers varied potential for returns and, correspondingly, their risk varies. Growth stocks and dividend yield stocks are relatively conservative.
  4. You can also initially gain exposure to equity shares via mutual funds. They are professionally managed. They offer good returns and optimal diversification. To further curtail your downside, you can use the systematic investment route, which will further reduce your risk given the benefit of rupee cost averaging.
  5. Derivatives are of a very high-risk cadre. It is recommended that, as a beginner, you stay out of this arena. Only after you have gained ample understanding of the derivative markets and if you are someone who closely monitors the market, then can you consider derivatives, particularly for hedging purposes.

It is always a good idea to seek the help of a professional who can guide you with your investments. Investing is a journey and not a destination. Hence, you need to continuously monitor and make strategic/tactical realignments to achieve optimized returns on your portfolio at risk-adjusted levels.

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