Why have derivatives?

Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset.
A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly.
The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives.
We will try and understand

• What are derivatives?
• Why have derivatives at all?
• How are derivatives traded and used?

In subsequent lessons we will try and understand how exactly will an underlying asset effect the movement of a derivative instrument and how is it traded and how one can profit from these instruments.

What are forward contracts?

Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few ‘smart finance professionals’. In reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor, can benefit immensely.
A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities.
Let us take an example of a simple derivative contract:

• Ram buys a futures contract.
• He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000.
• If the price is unchanged Ram will receive nothing.
• If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty.
Derivatives and futures are basically of 3 types:

• Forwards and Futures
• Options
• Swaps

Forward contract
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into.
Illustration 1:
Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.
Illustration 2:
Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency.
The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contract