Derivatives - CA Final AFM | CMA Final SFM | CFA Level 1

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Meaning of Derivative
• A derivative is a contract between two parties.
• Expected to be settled at a future date.
• Its Value is derived from the value of the underlying assets.
• No initial investment or very small amount of initial investment is required.

What is a Derivative Contract?
A derivative contract is a financial instrument whose value is derived from the value of the underlying. In other words, its value depends on the value of the underlying assets.

A derivative emerges out of a contract between two parties. It does not have any value of its own but its value in turn depends on the price movements of other assets underlying the contract, known as underlying assets (such as commodities, shares, bonds, foreign currencies etc.) or indices (such as stock market index, consumer price index etc.).

Derivatives are financial instruments that derive their values from price movement of underlying assets

The following example will help you to understand the meaning of derivative and underlying assets:

You want to acquire 500 equity shares in NJ Ltd. Each equity share is presently quoted at ` 1,000. You enter into a contract under which you can buy 500 equity shares in NJ Ltd. at ` 1,000 each. The contract gives you the right to buy 500 equity shares; it does not represent equity shares. The contract by itself has no market value. Suppose at later stage, these shares are quoted in stock market at ` 1,250. At this point your contract attains value. This is because; you can buy equity shares, now available in the market at ` 1,250, for just ` 1,000. The contract is now worth ` 250 x 500 shares i.e. ` 125,000/-. If the market price of such equity shares falls below ` 1,000 your contract becomes worthless.

Four conclusions can be drawn from this example:
1. The contract is a derivative instrument, it fulfills all the conditions of a derivative.
2. It gives you the right to buy the shares.
3. The underlying asset is the equity shares in NJ Ltd.
4. The value of the contract changes with changes in the price of the equity shares. It derives its value from the value of the equity shares.

While in the example given above, the underlying asset was equity shares, in the derivative market, the underlying asset could be commodities, precious metals, foreign exchange rate, and interest rate relating to financial assets and market indices.

Functions of Derivatives
1. Financial derivatives help in facing financial risk arising due to change in share prices, interest rates and currency rates.
2. The instruments known as financial derivatives provide a commitment to rates and prices for future date and thereby protect a party against future adverse movements.
3. Financial derivatives also provide opportunities to make profit for those who are ready to bear risk.
4. In the process, derivative transfer the risk from those who want to avoid it to those who are ready to take the risk.
5. Derivatives help in price discovery of the underlying asset.

Characteristics of Derivatives
1. The transactions in the derivatives are settled by the offsetting/squaring transaction in the same derivative. The difference in value of the derivative is settled in cash.
2. There is no limit on the number of units transacted in the derivative market because there is no physical asset to be transacted.
3. The derivative markets are usually computerized exchanges as against the trading market for physical assets.
4. Derivatives are only secondary market securities and cannot help in raising funds to a firm. In fact, derivatives arise only when the shares and debentures are already issued by the companies.
5. The derivative market is quite liquid and transaction can be effected easily.
6. The derivatives provide a hedging of price risk of financial transactions over a certain period. It is a contract to be settled in future, by cash payment of difference in price.

Types of Derivatives
Four types of derivatives have been in existence:
1. Forwards
2. Futures
3. Options
4. Swaps

Participants in Derivatives Market

Generally the participants may be classified into:
1. Hedgers,
2. Speculators and
3. Arbitrageurs

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