Derivatives are one of the most complex of instruments. The word “derivative” comes from the verb ‘to derive’. It indicates that it has no independent value. A derivative is a contract whose value is derived from the value of another asset, known as the underlying which could be a share a stock market index, an interest rate, a commodity or a currency. The underlying is the identification tag for a derivative contract. When the price of underlying changes the value of the derivative also changes. Without an underlying, derivatives do not have any meaning. For example, the value of a gold futures contract derives from the value of the underlying asset, that is, gold.
To understand the meaning of derivatives, let us take the example of a commodity such as cotton, which is the raw material for the textile industry. It may so happen that the price of cotton rises before and after the harvest but falls at the time off harvest. The farmer, who is exposed to such price fluctuations, can eliminate this risk by selling his harvest at a future date by entering into a forward, or futures, or futures, contract. This forward, or futures, contract takes place in the ‘derivatives’ market. The prices in the derivatives market are driven by the spot or cash market of the underlying asset, which is cotton in this example.
Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft, and so on. Derivatives, on the other hand, take care of market risks – volatility in interest rates, currency rates, commodity prices, and share prices. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. They offer a range of mechanisms to improve redistribution of risk, which can be extended to every product existing, from coffee to cotton and live cattle to debt instruments.
In this era of globalization, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however, is ‘risk-averse’. This risk averse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk averse individual by offering a mechanism for hedging risks.
Derivative products, several centuries ago, emerged as hedging devices against fluctuations in commodity prices. Commodity futures and options have had a lively existence for several centuries. Financial derivatives came into the limelight in the post 1970 period; today they account for 75 percent of the financial market activity in Europe, North America, and East Asia. The basic difference between commodity and financial derivatives lies in the nature of the underlying instrument. In commodity derivatives, the underlying is a commodity; it mat be wheat, cotton, pepper, turmeric, corn, oats, soya beans, orange, rice, crude oil, natural gas, gold, silver, and so on. In financial derivatives, the underlying includes treasuries, bonds, stocks,