A derivative is a financial contract between two parties, the value of which is derived from an underlying asset. Rather than trading or investing directly in the asset itself, participants enter into an agreement based on the asset's expected future price movements.
Here's a breakdown of the concept:
- Basis of Value: Derivatives don't have an inherent or standalone value. Their value is based on the price or rate of an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, or market indices.
- Time-bound Contracts: These contracts have an expiration date. Once they expire, they either result in a cash settlement or a physical delivery of the underlying asset, depending on the terms of the contract.
- Purpose and Use: Traders and investors use derivatives for various purposes including hedging (protecting against price movements), speculating (trying to profit from price movements), and gaining access to otherwise hard-to-reach markets or assets.
- Common Types of Derivatives: The most common types of derivatives include futures, options, forwards, and swaps.
Understanding Derivatives through an example:
Imagine you're a farmer who grows apples. You're expecting your apple harvest in three months, but you're concerned about the price fluctuations of apples in the market. To protect yourself from potential price drops, you decide to enter into a derivative contract.
- Futures Contract: You agree with a buyer today to sell your apples in three months at a fixed price of Rs. 100 per kilogram. This agreement is a type of derivative known as a futures contract.
- Scenario A - Price Drop: In three months, the market price of apples drops to Rs. 80 per kilogram. Thanks to your futures contract, you still sell your apples for Rs. 100 per kilogram, thereby hedging against the price drop.
- Scenario B - Price Rise: Conversely, if the market price of apples rises to Rs. 120 per kilogram in three months, you're still obliged to sell your apples at the agreed-upon price of Rs. 100 per kilogram. In this case, you would miss out on additional profits, but you had the certainty of the price when you entered the contract.
Through this derivative (futures contract), you, as the farmer, secured a guaranteed price for your apples, protecting against market uncertainity. This is a simple illustration of how derivatives can provide price security in volatile markets.
Note: While derivatives can offer protection, they can also come with risks. It's essential for participants to understand the terms of the contract and the potential outcomes before entering into a derivative agreement.
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