Derivatives can be complex, but we can break them down into smaller, more understandable concepts. Many people may not be familiar with derivatives, but most have heard of futures and options, which are types of derivatives. Futures and options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price.

• Futures: A futures contract obligates the buyer and seller to trade the underlying asset at a set price on a specific date.

• Options: An options contract gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a set price (strike price) before a specified date.

• Calls: A call option gives the buyer the right to buy the underlying asset at the strike price.

• Puts: A put option gives the buyer the right to sell the underlying asset at the strike price.

We'll explore derivatives further, one step at a time, to help you better understand these complex financial instruments.

Going to the IPL match as an Example 

Imagine you wanted to watch an IPL match in Dubai next month, but the tickets were sold out online. A friend with connections in Dubai gave you a letter that allowed you to buy a ticket for Rs. 3,000 from his friend anytime before the match.

As the match approached, ticket prices rose to Rs. 3,500 in the black market. Your letter became valuable because you could buy a ticket for Rs. 3,000, which was now worth Rs. 3,500. The letter was essentially worth Rs. 500.

The next day, ticket prices surged to Rs. 4,500. Your letter's value increased to Rs. 1,500. However, on the day of the match, you realized you couldn't attend due to a work commitment. You decided to sell the letter for Rs. 1,500, knowing its value would expire once the match started.

Let's analyze the reference letter:

• Right to buy: The letter gave you the right to buy a ticket at Rs. 3,000 anytime before the match.

• Acquired value: The letter gained value as the black market ticket price increased.

• Fluctuating value: The letter's value changed as the ticket price rose, deriving its value from the underlying asset (the match ticket).

In financial terms, the letter is a derivative instrument, a contract that derives its value from an underlying asset (the match ticket). Derivatives can take many forms, but their value always depends on something else.

Financial Derivatives

In the financial markets, derivatives are contracts that derive their value from underlying assets like stocks, commodities, currencies, or indices. They help investors manage price fluctuations and risk, providing a way to:

• Hedge: Reduce potential losses by locking in prices

• Speculate: Bet on price movements without owning the asset

• Leverage: Control larger positions with smaller capital

Key Points:

• Derivative: A financial instrument that derives its value from an underlying asset

• Types of Derivatives: Futures, Options, Forwards, and Swaps

• Buying a Derivative: This means buying the right to buy or sell an underlying asset at a specified price

• Right to Buy/Sell: The buyer of a derivative gets the right to buy or sell the underlying asset, but does not own the asset itself

• Cost: The cost of buying a derivative is typically much lower than the actual price of the underlying asset

• Expiration Date: Derivatives have a fixed expiration date, after which the right to buy or sell expires

• Underlying Assets: These can be stocks, commodities, currencies, treasury bills, bonds, or indices

Example:

• Buy the right to buy Infosys shares at Rs. 1010 for Rs. 15

• If the share price rises to Rs. 1200, you can exercise your right to buy at Rs. 1010 and sell at Rs. 1200, earning a profit of Rs. 175

In Summary:

Derivatives are powerful financial instruments that allow investors to manage risk and potential profits by buying the right to buy or sell underlying assets. They offer flexibility and leverage, but also involve risk, so it's essential to understand them thoroughly before trading.