What are Derivatives?

Written By: Roshni Bhatia on March 1, 2012 No Comment Meaning of Derivatives: Derivative is an instrument that does not have a value of its own, rather it derives its value/price on the basis of some other instrument, hence the name Derivative. For eg, Cheese, curd, ice-cream etc. can be termed as derivatives of milk products. Their price is dependent on the price of milk, which, in turn will depend on the demand and supply of milk. Have you not wondered how do Mutual Fund units tend to change daily? On what basis does that value change? Dont they derive the value from the value of individual securities in the portfolio of the schemes? Are they derivatives then? And what about the ADR/GDR of Satyam/Infosys which are traded on USA/England stock exchanges? Do they have their own value? Or even they derive their value from the shares in India? So, now I guess you get the point. Definition of Derivatives: Derivatives are financial instruments/contracts that derive their value from some other underlying/underlying asset. What is Underlying/Underlying Asset?

What are the characteristics of Derivative instruments?

What is the basic purpose of Derivatives? When it comes to derivatives, the gain of one is the loss of other. Main Aim: Transfer of risk from one party to another (in other words, insurance). Though, it must be noted that some people make use of derivatives solely for profit making. This leads to understanding of different operators in the Derivatives Market. Who are the Operators in the Derivatives Market? There are basically three kinds of operators in this market: Hedgers, Speculators and Arbitragers. Hedgers: The operators, who try to manage the risk using derivatives, are called as Hedgers. Hedgers seek to protect themselves against price changes in a commodity in which they have an interest. Example: Raj wants to purchase a car, which costs Rs 8,000 but does not have enough cash to buy it outright. He will be able to purchase it only 3 months hence. He, however, fears that prices of cars will rise 3 months down the line. Hence, in order to protect himself from the rise in prices Raj enters into a contract now with a car dealer that he will purchase the car three months from now for Rs 8,000. What Raj is doing is that he is locking the current price of a car for a forward contract. The forward contract will be settled at maturity. The dealer will deliver the car to Raj at the end of three months and Raj in turn will pay cash equivalent to the car price on delivery. So, in future if the car prices move in an unfavorable direction, i.e. happen to rise (in this case) then too Raj can buy the car at Rs. 8000. It is very important for exporters/importers, traders, dealers, etc. to protect themselves against unfavorable price conditions. Speculators: They are traders who dont mind taking risks in order to make profits, by taking advantage of the favorable movement of the underlying. They bet on the direction of markets, if they would go up or come down and try to generate profits from it.

Arbitrageurs: Arbitrage means to take advantage of a lower current market price in comparison with the future value of the asset. Aim: Risk-less profit making is the prime goal of arbitrageurs. They are adept in buying and selling in different markets at the same time and profit by the difference in prices between the two markets.

Source: Tradestation.com

As we just mentioned about hedging and risk management, can we term Derivatives as Insurance? One purchases a life insurance policy and thereby pays a premium to the insurance agent as per policy terms for a fixed duration. If you are alive, then you are glad and the insurance company is glad. If you happen to pass away, your relatives are glad as the insurance company will have to pay them the amount for which you are insured. Insurance, in simple terms, can be termed as transfer of risk. An insurance company essentially is selling to you a risk cover and buying your risk and you are selling your risk and buying a risk cover. The risk in case of in life insurance is the demise of the policyholder. The insurance company bet on ones being alive and thereby agree to sell a risk cover for certain amount of premium. The risk transfer occurs in turn of a financial cost which is premium. Considering that, a derivative instrument is comparable to insurance, as it involves a risk transfer at a financial cost. Why are Derivatives Important? Are they risky? Derivatives play a significant role across the global markets as instruments of risk management. They are extensively used for minimizing risks and transferring to those who are essentially willing to take risks. Derivatives grant market participants an easy/less expensive way in which one can build their desired portfolio with minimum level of risk. They are risk management and portfolio restructuring tools. Considering that, one might wonder why derivatives are risky. So, here lies the answer: LEVERAGE!!

This in simple terms means that one could take position in the markets in multiples of the resources one possessed. You just have to pay a small amount of margin in order to take a position, so it involves high leverage. As a result, participants tend to take positions that are much higher than their risk taking capabilities and if the market moves in unfavorable directions, they suffer with extremely high losses. At the end of it, this can be perceived as a problem of the participants in the market and not of derivatives.

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