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Financial Derivatives: Concept, Purpose

CONCEPT OF DERIVATIVE

In the Indian context the Securities Contracts (Regulation) Act, 1956 SC(R) A, defines “derivative” as —

“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”.

“A contract which derives its value from the prices, or index of prices, of underlying securities”

“Financial instruments that linked to a specific financial instrument or indicator or commodity and through which specific risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index.

Unlike debt securities, no principal is advanced to be repaid and no investment income accrues.”

The International Monetary Fund (IMF)

“A derivative is a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables” – John C. Hull

“A financial instrument “which has a value determined by the price of something else. This “something else” can be almost anything: it can be assets or commodities”.

Robert L. Mc Donald

Derivative instruments are used for varied purposes i.e. managing risk by managing funds; making profit by taking risk, and taking advantage of price differentiation in different markets at any given point of time. Accordingly, there are varied types of trades or participants who trade in the futures and option market. Those are hedgers, speculators and arbitrageurs, who constitute three major classes of such trader.

Derivatives are used for the following:

  • Hedge or to mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
  • Create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)
  • Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
  • Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative
  • Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level)
  • Switch asset allocations between different asset classes without disturbing the underlying assets, as part of transition management
  • Avoid paying taxes. For example, an equity swap allows an investor to receive steady payments, e.g. based on LIBOR rate, while avoiding paying capital gains tax and keeping the stock.
  • For arbitraging purpose, allowing a riskless profit by simultaneously entering into transactions into two or more markets.

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