CONCEPT OF DERIVATIVES

Risk is all pervasive; no one can escape it. However, risk can be managed.

From the perspective of management, risk can be classified as a. small losses

with high probability of occurrence and b, large losses with low probability of

occurrence. Business risk predominantly emanates from changes in price,

exchange rates, and interest rates.

 MEANING FOR FINANCIAL DERIVATIVES
A derivative is a financial product which has been derived from another financial product or commodity.
D.G. Gardener defined the derivatives as “A derivative is a financial product which has been
derived from market for another product.” .
The securities contracts (Regulation) Act 1956 defines “derivative” as under section 2 (ac). As per
this “Derivative” includes (a) “a security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract for differences or any other form of security.”
(b) “a contract which derived its value from the price, or index of prices at underlying securities.”

The above definition conveys that the derivatives are financial products. Derivative is derived
from another financial instrument/ contract called the underlying. A derivative derives its value from
underlying assets.
Accounting standard SFAS133 defines “a derivative instrument is a financial derivative or
other contract which will comprise of all three of the following characteristics”.
CONTINUED…,
Derivatives are defined as “instruments that derive their value
from some other asset called that underlying asset. They serve the
purpose of managing the risks involving small losses with high
probability rather than risks having potentially large losses with
small probability.” The business environment is full of risks
involving small losses with relatively large probabilities.
Derivatives are products that derive their value from some
other asset called the underlying asset.
 CONTINUED…,
Derivative is a contract whose value is derived from the price of
the underlying asset, but in all other respects remains distinctly
independent from the underlying asset.
Derivatives are “instruments that derive their value on the basis of
prices of some other asset, called the underlying asset. These
underlying assets can b e physical commodities or financial
securities or may be notional that are devoid of physical
substances but have financial implications”.
CONTINUED…,
What Is a Derivative/Financial Derivative?
A derivative is a contract between two or more parties
whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets
(like an index). Common underlying instruments include
bonds, commodities, currencies, interest rates, market
indexes, and stocks.
 THE FOLLOWING EXAMPLE ILLUSTRATES THE MEANING OF A DERIVATIVE PRODUCT

Consider that, an Indian exporter is expecting to realize 1000 Dollars in six

months’ time from now. The exporter had priced his product with a profit target
of Rs 2000 based on the current market price of dollar at Rs 45. The actual
amount that will be realised by him in Indian reupees will depend upon the
exchange rate prevailing six months later. This rate is not known today. The
exporter expects Rs 45,000 but he might end up getting Rs 44000 if the
exchange rate falls to Rs 44/Dollar. If the rate falls to Rs 44, his profit will stand
reduced by Rs 1000. Although he cannot control the price of the dollar in the
currency market or his profit, he can take protective measures to reduce the
uncertainty of the exchange rate and consequential profit.
DERIVATIVE PRODUCTS
Forward Contract
Future Contract
Options Contract
Swaps