What are Derivatives? | Types of Financial Derivatives

As Warren Buffett said “Derivatives are Financial Weapons of mass destruction”

Derivatives Meaning

A derivative is a product whose value is to be derived from the value of one or more basic variables called bases (underlying assets, index, or reference rate). The underlying asset can be Equity, Commodity, and Forex.

Underlying Variable Meaning | What is underlying in Derivatives?

Now we need to understand the underlying asset/security means in the valuation of a derivative product.

  1. Underlying Asset in Derivative: The underlying assets are financial assets upon which the market value of the derivative is based on.
  2. Types of underlying asset in Derivatives: There are many types of underlying asset:
    • Security (Tata Motor, Reliance)
    • Currency (Dollar/Pound)
    • Market Index (Nifty/Bank Nifty)
  3. Examples:
    • In security option contracts, the underlying asset is the stock itsels. Let’s say, stock option of Tata Motor (CMP: Rs. 321.75) at Rs. 320 strick price is Rs. 17.5. You have the choice to buy or sell this option contract up until the expiry. Here, for the option of Rs. 17.5, the underlying asset is the stock of Tata Motors.
    • In case of Index (Nifty/Bank Nifty Options), the underlying contract is comprised of the common stock within the index.

Importance of Underlying Derivative Instruments

The underlying (asset, index, or reference rate) has a market value that is subject to market risk. The importance of underlying derivative instruments are as follows:

  • On Maturity, the position of profit/loss is determined by the price of underlying instruments

If the price of Underlying is higher than the contract price, then the buyer makes a profit, and if the price is lower, then the buyer suffers a loss.

  • In absence of a valuable underlying asset, the derivative instrument will have no value.
  • All derivative instruments are dependent upon an underlying asset to derive its value. For example, a change in the forward contract is broadly equal to the change in the value of the underlying.
conclusion of the contract, handshake, trade

Types of Derivatives

There are 2 types of Derivatives:

  1. Financial Derivatives: A financial derivative is a product which is traded between two or more parties whose value is based on an underlying financial asset. Types of Financial Derivatives are:
    • Options
    • Futures
    • Forwards
    • Swaps
                                •  
  2. Embedded Derivatives: Embedded Derivative is a derivative instrument that is embedded in another contract (i.e. the host contract). The host contract might be a debt or equity instrument, a lease, an insurance contract, or a sale or purchase contract. For eg, a coal purchase contract may include a clause that links the price of the coal to a pricing formula based on the prevailing electricity price.

Author’s Note: We will be covering all these topics in detail, in future blogs. You can subscribe to the newsletter to get these blogs on your email.

Participants in Derivative Market

Main users of Derivatives are as follows:

S. No.UsersPurpose
1Corporation To hedge currency risk and inventory risk
2Individual InvestorsFor speculation, hedging, and yield enhancement
3Institutional InvestorsFor hedging asset allocation, yield enhancement, and to avail arbitrage opportunities
4DealersFor hedging position-taking, exploiting inefficiencies, and earning dealer spreads
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