Literally derivative is something which is derived. Now you may ask what is derived? The entire value is derived from the underlying assets. What is the underlying asset? The underlying assets are the securities, commodities, bullion, currency, livestock, or anything else. Security derived from the debt instrument, share, or loan whether secured or unsecured.
Derivative is a financial contract between a parties which value is derived from an underlying assets. It has no direct value and the value of derivative is based on the expected future price movements of their underlying assets.
Types of Derivatives
Usually, there is two types of derivatives, such as :
- Commodity Derivatives
- Financial Derivatives
In a commodity Derivatives, the underlying asset is a commodity. The commodity is cotton, pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold, silver, copper and so on. Commodity derivatives have the quality issue.
The financial derivatives include stocks, bonds, treasury bills, interest rate, foreign currencies, and other hybrid securities. Financial derivatives are futures, forwards, options, swaps etc. Financial derivatives can also derive from a combination of cash market instruments, or other financial derivative instruments.
Financial Derivative is more than a complex issue than commodity issue. Financial derivative is fairly standard and there are no quality issue like commodity derivative. Financial Derivatives can be classified is as follows:
Forward Contract is a binding agreement between parties to exchange a set of amount of goods at a set future date at a price agreed today. This is the contract which
Forward Contract is an agreement between two parties where both parties will agree to abide the terms and conditions and to make the settlement in a future as today’s pre-agreed price as mentioned in the agreement.
Example of Forward Contract:
Kit kAt is a manufacturer of chocolate. The main raw materials of chocolate is cocoa beans. They plan to purchase cocoa beans for future production and wants to acquire them for a fixed price.
The manufacturers can achieve this by agreeing with the producer of cocoa beans to purchase a quantity for delivery at a specific date in the future at a price agreed now.
In January, when the price of a consignment of cocoa beans is $ 1,000, the chocolate manufacturer agrees to a price with the supplier of $ 1,100 for delivery at the end of March. As the market is volatile the price jumped to $ 1,500. How much Kit
As they have entered into Forward Contract, Kit KAt will pay $ 1,100.
The price for both parties is now set – and thus whilst the market price in March may be higher or lower than the agreed price of CU1,100, the benefit for both parties is that they have certainty, and so are better able to plan and budget effectively.
Future Contracts are special types forward contract, where buyer are obligate to buy the assets and seller, are obligates to sell an asset at a certain time in the future at a predetermined price. This can be used to hedge or speculate on the price movement of the underlying asset.
The purpose of the futures contracts is not only to gain from favorable price movements but also prevent losses from potentially unfavorable price changes.
An option is an agreement giving the buyer of the option the right, but not the obligation, to buy or to sell a specific quantity of something (e.g. shares in a company, a foreign currency or a commodity) at a known or determinable price within a stated period.
There are two types of option:
- Call Option
- Put Option
Call option gives the buyer the right but not the obligation to buy an underlying asset at a pre-determined price on or before a given future date.
Put Option gives the buyer the right but not the obligation to sell an underlying asset at a pre-determined price on or before a given future date.
Derivatives are designed for hedging, speculation or arbitrage purpose. The Future and Forward market are the outcome of derivative securities where buying and selling of securities are incurred in advance but settled on a future date. The users use the derivative not only make the gain from the underlying securities, but also to mitigate the risk arising from future price movements.