Financial Derivatives: Definition, Types, Risks

Derivatives may have gained popularity in the 21stcentury, but the origin of this financial instrument goes back to Mesopotamian times. The King had passed an order that “if” a situation of insufficient crops arises due to inadequate rains, lenders will have to forego their debts to the farmers. Derivatives have come a long way since then. Read on to know more about them.

In simple terms, a derivative is a contract, and the value of this contract depends on a particular asset. The assets from which the derivatives derive their value are called ‘the underlying assets or the underlying.’The underlying asset can be equities, indices, currencies, commodities, bonds or even another contract (derivative). Since the value of the derivative or the contract stems from the underlying assets, so any change in the value of the underlying assets causes a difference in the value of the derivative.

There are two primary purposes of derivatives - hedging and speculation. When a party enters into a derivative contract, it tries to protect itself from a possible risk that might occur from a commercial activity over a given period. This is essentially a hedging policy which mitigates the potential loss that can befall in case of an unfavorable event.For example, consider the producers of wheat and manufacturers of bread. If there is a fall in the price of wheat, it is bad for the wheat producers but good for bread manufacturers. However, a rise in the price of wheat will be beneficial for its producer but will raise the raw material cost for bread manufacturers.Price of wheat can go either way. If the wheat producer believes that the price of crop will decrease in future and the bread producer expects the price to increase, they can enter into a derivative contract to safeguard themselves from the potential risk. They can have a contract of selling/buying a certain amount of wheat in the future at a pre-determined price.

Another purpose of entering into a derivative contract is to earn profits by speculation. Derivative speculators are driven by the opportunity of profits that can arise from fluctuating market conditions. Speculators analyze and forecast the market shifts and accordingly, buy contracts and sell them at a higher price or sell contracts and buy them at a lower price at a given point in time.

Before one starts trading into derivatives, it is essential to conduct an extensive research about their types and know the process of derivatives trading. Also, the general rules and terms of derivative trade must be well-known out before venturing.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.