Introduction to Derivatives.

Derivatives have become very popular during the past two decades. The real purpose of derivatives is to allow traders to maximise returns and simultaneously limit their risk exposure. However, common investors have developed speculative interest with derivatives. It’s a complex subject and here, I am trying to crack down this subject in a step by step approach. May be you are not used with the term ‘derivatives’ but if I say  ‘Futures and options’ or ‘F & Os’ or ‘calls and puts’ I’m sure all of you would understand what I’m talking about.



GOING FOR THE A.R. RAHMAN CONCERT.

The objective of this story is to introduce you the term ‘derivatives’. After finishing the story, I will break up the explanation into maximum pieces as possible! Let’s begin our story –

You want to watch the A R Rahman concert scheduled next month. You find from the advertisements that entry ticket costs Rs 1,000. You call up the booking counter only to find that tickets are fully sold out! You approach a friend who is part of the concert team for a ticket and he gives you a reference letter under which if you show the letter you can buy a ticket by paying Rs 1,000. As the concert date draws closer, tickets are being sold in grey market at Rs 1,500. Now, the reference letter you have attains value because of the simple reason that you can buy a ticket, now available in the market at Rs 1,500, for Rs 1,000. That means your letter is worth Rs 500. Two days before the concert, the price in the grey market shoots up to Rs 2,000, the value of your letter increases to Rs 1,000.

But, on the concert day, you get a call from your office. There’s an important assignment to be done. So you decide to sell this letter to someone who is wiling to pay Rs. 1,000 to you. You can’t afford to postpone the sale because, once the concert starts, your letter becomes worthless.

Forget about what happened after that. Instead, we will discuss more about that letter you had with you. Let’s try to understand the features of that letter.

  • That letter gave you a ‘right’ to buy a ticket at Rs 1,000. When? – Anytime before the Concert starts.
  • The Letter gained value. How? Grey market rate of the tickets shot up.
  • The value of the letter kept changing. Why? Because the price in the grey market kept increasing. So, the value of the letter is ‘derived’ from the value of the ticket it represents.
  • In pure financial language, this letter will be called a ‘derivative instrument’.
  • A ‘derivative instrument’ is nothing but a contract (in this case –the letter) whose value is derived from the value of the underlying asset (in this case –The concert ticket)


FINANCIAL DERIVATIVES

Now I hope you are clear about the term. The concert ticket was an imaginary derivative instrument. We generally don’t find such ticket derivatives in real life.  The real ones are derivatives in financial markets. These derivatives are widely traded to guard against price fluctuations. We will discuss the uses of derivatives against price fluctuation in a different chapter. For the time being, let’s wind up this article by discussing what a financial derivative is -

  • Derivative is a general term.
  • Derivative literally means ‘derived from’.
  • These are nothing but financial instruments that can be bought and sold.
  • Futures and options are types of derivatives.
  • What it carries is a ‘right’. When you buy derivative, you buy a ‘Right’. In normal stock market trading, we buy and sell shares. But in this case, the stock is not traded instead; the right to buy or sell a share is traded.
  • Note that, ‘the right’ may be ‘The right to buy’ or ‘the right to sell’.
  • But, this right, to buy or sell, cannot be held on forever. The exchange sets a cut off date before which you have to either exercise your right or sell off the right to another person.
  • The ‘cost of buying a right’ is very less compared to the actual stock price.
  • For example – you hold the right to buy Infosys at Rs. 2000 per share today. You bought the right for Rs 200. Now, after a few days, Infosys’s shares are trading at Rs.2500. But you can buy it at Rs 2000 since you have purchased the right to buy Infosys at that price.Naturally, since the price in cash market is Rs 2500, you can exercise the right to buy at Rs.2000 and sell it at Rs.2500. So, your investment of Rs 200 gave you return of Rs 300 ( Total cost = 2000 + 200) because the underlying asset (shares of Infosys) went up in value.
  • So, buying a derivative does not result in acquiring a share, but it results in ‘buying the right’ to buy a share or to sell a share.
  • In other words, the buyer of a derivative gets a right over an asset (shares) which after a certain period of time might result in the buyer buying or selling the asset.
  • Not only shares, the base asset can be anything like commodities, foreign currency, treasury bills, bonds or share indices.
  • In fact, any transaction that results in a right without actually transacting the asset becomes a derivative instrument.
  • All derivative instruments are not the same. They differ when it comes to the kind of obligation it creates on the holder.
  • Forwards, Futures , Options and Swaps are the types of instruments that are clubbed under this general term.

Will catch up with each of these types in up coming articles..

Till then

Have a nice time.

(The credit for the  story goes to my teacher who introduced derivatives to me..i’ ve just given some touch ups to it)

You may like these posts:

  1. Investment advisors- An introduction.
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  3. Introduction to financial statements

19 Responses to “Introduction to Derivatives.”

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Anonymous

December 11, 2011 at 2:31 am

I am really satisfied with this posting that you have given us. This is really a stupendous work done by you. Thank you and looking for more posts

ss

April 2, 2012 at 9:32 pm

Thanks for making it interesting & simple
Now i expect to understand derivatives more in my further readings

divya

May 11, 2012 at 2:09 pm

hey that was one of the best explanations to derivatives… would recommend it to my classmates.. gr8 work.. keep goin \m/

Harris

June 4, 2012 at 8:24 am

I genuinely like this internet site, will surely come back once again.

Sricharan

August 18, 2012 at 12:22 pm

I like the way you explain the things in a simple way which anyone can understand.

Thanks for such a great website and keep going with your work.

J Victor

August 19, 2012 at 9:45 pm

Thankyou :)

anil

October 7, 2012 at 12:21 pm

Very good explanation. Thank you and your teacher.

J Victor

October 8, 2012 at 7:27 am

thanks :)

Ujas Ajmera

December 17, 2012 at 11:21 pm

Easy to learn and investor friendly… :)

Lalit

January 30, 2013 at 6:32 pm

Superb illustration given. Nowhere other than this i got such simple & understandable info. about deerivatives…nice 1 :)

John

March 11, 2013 at 11:11 am

Jins, as i go on reading & reading, things are becoming more & more crystal clear. I was not getting a clear picture of derivatives. but, with your story about the concert ticket you made it so easy. Wow how easy & clear in laymans lingo things are explained. Otherwise, on other website, i only get to read in financial jargons which makes it difficult to read further. Man, you are too good, i wouldn’t hesitate to recommend this to newcomers. I think I am becoming smart now. Keep it coming. GOD bless you.

Mihir Manohar

January 31, 2014 at 3:32 pm

That’s seriously awesome!!!
I am just a beginner. This is the complete example for a learner.
Please do continue this work…. to make the subjects lucid and easy to understand.

Vikrant Kalpande

December 4, 2014 at 9:41 am

Victor..you are awssoommeeee!!!!

santosh

June 7, 2015 at 7:31 pm

Great u have explained such a difficult subject in very lucid and simple language You r awesome teacher

kannan

July 24, 2015 at 8:45 am

Good explanation by narrating simple event.
Also suggest to provide a simple example of trading in F & O

Vivek Chandak

January 16, 2016 at 4:38 pm

Great way to help people to understand !! Such a lucid and to the point explanation.

marily

April 9, 2016 at 8:16 pm

Great explanation thanks a lot!!

Richie

May 22, 2016 at 10:41 am

Thanks for the explanation , I was taught this several times but I couldn’t get it well until your explanation God bless you.

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