INTRODUCTION TO DERIVATIVES

A Derivative is a contract whose value is determined from an another asset,  known as underlying. an underlying could be anything which has its own value and can be traded in the market.

An underlying could be a share(equity or preference), a stock market(Nifty or SENSEX), a commodity(rice,wheat etc.), a currency  (Rupee,Dollar etc.) or even whether. Value of a derivative depends on the value of its underlying. without underlying derivative don’t have any meaning.

for example, the value of a ‘gold futures’ derives  from the value of gold. here gold is the underlying.

the main objective behind introduction of derivative was to reduce the likely loss in the value of asset due to uncertain fluctuations. it’s like insurance. insurance protect us against specific risks, such as fire, flood and theft. Derivatives on the other hand takes care of all market risks in the world of finance.

Definition of Derivative as per securities contract (Regulation) Act 1956 –

derivatives include the following

  1. a security derived from a debt instrument,share,loan(whether secured or unsecured), risk instrument, or contract for difference, or any other form of security.
  2. a contract which derives its value from a price or index of prices of underlying securities.

CHARACTERISTICS OF A DERIVATIVE CONTRACT –

  1. Binding on both parties – A derivative instrument relates to the contract between two parties. it means the contract must be binding to the parties and to be fulfilled in future. the future period may be short or long depending upon the nature of contract.
  2.  Counter party obligation – both the parties have specific obligation to be fulfilled.
  3.  It s based on underlying
  4. Direct or Indirect contract – the derivative contract can be taken directly known a forward contract  or with the help of future contract through stock exchange.
  5. Usually in derivatives trading the delivery of underlying assets does not happen.
  6. Derivatives are also known as deferred delivery or deferred payment instrument.
  7. these are generally secondary market instrument and have little usefulness in mobilising fresh capital by the corporate world, however warrants and convertibles are exceptions to this.
  8. Although the market for derivatives is standardised, some over the counter exchanges for derivatives trading are also available.
  9. Derivative instruments are sometimes used to cleat up the balance sheet.

TYPES OF DERIVATIVES

(a) Commodity Derivatives – In commodity derivatives, the underlying is a commodity which may be wheat,cotton,pepper,sugar,jute,turmeric,corn,soyabeans,gold,silver etc.

(b) Financial derivatives – in a financial derivative, the underlying instrument may be any financial asset like treasury bill,stocks,bonds,foreign exchange,stock index,gilt-edged securities,cost of living index etc. financial derivative is fairly standard and there are no quality issue,whereas in  commodity derivative,the quality of the underlying may matter a lot

These financial derivatives can be mainly of three types –

  1. futures
  2. forward
  3. options