Derivative

Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying asset (often simply known as underlying).These contracts are legally binding agreements, made on trading screen of stock exchange, to buy or sell an asset in future. The asset can be share, index, interest rate, bond ,rupee dollar exchange rate ,sugar , crude oil, soya been, coffee etc. Everybody wants to know about them, everybody wants to talk about them. Derivatives however remain a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products A simple example of derivative is curd, which is derivative of milk. The price of curd depends upon price of milk which in turn depends upon the demand and supply of milk. Section 2(aa) of Securities Contract (Regulation) Act 1956 defines Derivative as: "Derivative" includes - • “a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; • a contract which derives its value from the prices, or index or prices, of underlying securities ”. A working definition of derivative which will help to lay foundation. “A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables.” ---John C. Hull Derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance. Example Suppose you have a home of Rs. 50, 00,000. You insure this house for premium of Rs 15000 (It is a very risky house!) Now you think about policy (ignoring the house) as an investment. • Suppose the house is fine after 1 year. You have lost the premium of Rs 15000. • Suppose your house is fully damaged and broken in one year . You receive Rs 50,00,0000 on just paying premium of Rs 15,000.If you have bought insurance of any sort you have bought an option. Option is one type of a derivative.