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.
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