An asset class is a group of securities that show similar characteristics, behave in a similar way in the market and are governed by similar rules and regulations. Each asset class has its own risk and return profile, cash flows and perform in different ways in different environments.
Due to these differences, asset classes can be used for the purpose of diversification by investors. By investing in different asset classes, the investors can diversify their portfolio risks and increase their probability of receiving high returns.
Some of them are equity or stocks, fixed income securities or bonds, cash or marketable securities, commodities and derivatives. There are a few other alternative asset classes as well as artwork and real estate, but because of being alternative they are less liquid.
The purpose of different asset classes is to make it easier and more organised for the investor to know which class has what amount of risks and returns and then to make his portfolio accordingly.
When an investor decides to build an investment portfolio, he is actually deciding what proportion of his capital will be invested in which asset class, depending upon his short term and long term objectives, liquidity requirements, capital availability, risk appetite, age and other personal factors.
Going by the definition of an asset class, Derivatives are an asset class.
It is because the entire derivatives market has its own unique characteristics, rules and regulations and all the derivatives behave in a particular way in the market.
Derivatives offer risks and returns that are unique to them. Derivatives derive their value from the underlying assets so it can be sometimes misconstrued that those underlying assets like stocks, currency, interest-rate are an asset class and derivatives are not.
But, in a true sense, the way how derivatives with underlying assets as stocks behave are very different from how stocks in general behave.
Derivatives form a separate asset class because of its own different characteristics. The kind of risk management and returns derivatives provide is way different from the risk and returns of an underlying asset.
For example, how an investor deals with and is affected by the shares of a company varies from how he deals with the futures of that company.
Although, the spot price and future price of a stock are related to each other and move in the same direction, however, the kind of risks and returns an asset provides are not similar to what its derivative provides.
Therefore, when an investor wishes to decide on the diversification of his portfolio, if he chooses stocks as one asset class due to high liquidity, high returns but high risks, he may also add derivative of that stock as another asset class to diversify risks of his portfolio by choosing an asset class which helps in hedging risks that he decided to take over by choosing stocks.
Additionally, by being an asset class, derivatives give an opportunity to the investor to get exposure to all forms of underlying assets like stocks, commodities, foreign exchange, real estate and so on.
Thus, the investor’s portfolio gets more diversified as he is not just investing in a separate asset class but the one that gives an understanding and taste of different categories.
Therefore, derivatives are an asset class and an important one to that. They help an investor in the diversification of his risk profile and get unlimited profits by keeping the losses limited.
The market exposure provided by derivatives is very different and unique as compared to the exposure provided by the underlying assets like currency, stocks, gold, real estate and so on.
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