In simpler terms, the value of a derivative depends on the value of something else, which is otherwise called the underlying of the derivative. Hence, the value of the shares of a company is the underlying in the case of stock derivatives.
Similarly, it is the value of the index the underlying for an index derivative, and the value of crude oil the underlying for a crude oil derivative.
The value of the derivative also changes due to demand and supply but the primary mover of the change in value of the derivative is the change in the value of the underlying.
Various underlying assets
Derivates cover the entire gamut of trade and services available in the markets, from equities, equity indices, to commodities such as crude oil, cotton etc, to bullion like gold, silver and even weather derivates among others.
Types of derivatives
In India, there are many types of derivatives such as forwards, futures, options, swaps, warrants, LEAPS, baskets, and swaptions. However, the most common of all is the futures and options derivatives.
As the very name implies, futures derivative is a derivative contract that enables the buyer and the seller to pre-decide the quantity, rate and date of a future purchase of an asset. For example, A agrees to sell to B a futures derivative contract of XYZ company's 300 shares valued at Rs. 5400 after the expiry of 3 months.
On the expiry of 3 months, which is the pre-decided date, A, the seller of the futures contract gives to B, the buyer of the futures contract, the delivery of the XYZ Company's 300 shares at Rs. 5400.
Thus, any difference, increase or decrease in the value of the shares on the delivery date of the shares will not affect the futures contract as the rate has already been pre-decided.
That is, both the buyer and the seller in a futures contract must honor their commitments to make and take the delivery according to the terms of the contract this despite the differences in the buying or selling price due to market conditions.
Buying a futures contract does not involve any upfront cost however there is brokerage charges.
Another widely used derivative is the options derivatives, which are more flexible than futures and works more in favor of the buyer of this type of derivatives.
As the name hints, the buyer of the derivatives is not obliged to take the delivery of the asset on the delivery date. In simpler terms, the buyer has an option to take delivery of the asset on the agreed date.
Obviously, the decision to take or not to take largely depends on the market price at the delivery time. If there is an increase in the market price of the asset, the buyer of the options derivatives would obviously exercise it and make profits.
And in this case the seller of the options derivatives must honour the option to deliver the assets. However, if there is a drop in the market price of the asset, the buyer may not exercise his option thus allowing it to lapse.
The pre-decided price fixed in the case of options derivatives for the exchange of asset is called the strike price. However, this exchange of asset is not exercised by the buyer and is instead sold in the market to make profits. This is primarily due to the fact that when the option price goes up it only makes sense to make profit by selling it instead of exercising it to exchange assets.
Considering the fact that options derivatives favor the buyer more and exposes the seller to the risk of price movement, the buyer pays the seller an option premium or option writer simply a fee for the risk involved for the seller.
Two types of options derivatives
Options are of two types: American and European. American options are more flexible as it enables to exercise the option any time upto the settlement date. In India, only American options are traded.
Unlike the American options, the European options allow it to be exercised only on the settlement date.
Use of derivatives
Perhaps the main use of a derivative is hedging the risk. That is by buying a derivative the cash flow is ensured and losses limited.
For example, an exporter expects earnings in foreign currency after a period of time but since the spending is done in the local currency as well he would also prefer to keep track of the earnings in the local currency to know the exact earnings.
And only on till the expiry of the period of time and based on the actual conversion rate prevailing at that time can the exporter know his actual earnings in the local currency. Since then an ambiguity persists with regard to the actual earnings.
In this scenario buying derivatives could help predict the actual earnings even after the period of time and despite the volatile conversion rates.
Apart from hedging, which is the chief reason why derivatives are used in the markets, there are other participants using derivatives but only for investments, stocks derivatives for instance. This actually injects liquidity into the derivatives system and hence is considered good.