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Introduction to derivatives

Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture.

Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.

Derivatives are an important class of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies.

Derivatives may be traded for a variety of reasons.

1. Hedging

A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market.

2. Speculation

Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.

3. Arbitrageur

A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices.

As defined above, the value of a derivative instrument depends upon the underlying asset. The underlying asset may assume many forms:

* Commodities including grain, coffee beans, orange juice;

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