Page 8 - DCOM510_FINANCIAL_DERIVATIVES

Unit 1: Introduction to Derivatives

(iii) Its terms require or permit net settlement. It can be readily settled net by means Notes
outside the contract or it provides for delivery of an asset that puts the recipients in
a position not substantially different from net settlement.
The term “financial derivative” relates with a variety of financial instruments which include
stocks, bonds, treasury bills, interest rate, foreign currencies and other hybrid securities. Financial
derivatives include futures, forwards, options, swaps, etc. Futures contracts are the most important
form of derivatives, which are in existence long before the term ‘derivative’ was coined. Financial
derivatives can also be derived from a combination of cash market instruments or other financial
derivative instruments. In fact, most of the financial derivatives are not revolutionary new
instruments rather they are merely combinations of older generation derivatives and/or standard
cash market instruments.

In the 1980s, the financial derivatives were also known as off-balance sheet instruments because
no asset or liability underlying the contract was put on the balance sheet as such. Since the value
of such derivatives depend upon the movement of market prices of the underlying assets, hence,
they were treated as contingent asset or liabilities and such transactions and positions in
derivatives were not recorded on the balance sheet. However, it is a matter of considerable
debate whether off-balance sheet instruments should be included in the definition of derivatives.
Which item or product given in the balance sheet should be considered for derivative is a
debatable issue.

Did u know? The underlying securities for derivatives are:
(a) Commodities (Castor seed, Grain, Coffee Beans, Pepper, Potatoes)

(b) Precious Metals (Gold, Silver)
(c) Short-term Debt Securities (Treasury Bills)
(d) Interest Rate
(e) Common Shares/Stock

(f) Stock Index Value (NSE Nifty)
In brief, the term financial market derivative can be defined as a treasury or capital market
instrument which is derived from, or bears a close relation to a cash instrument or another
derivative instrument. Hence, financial derivatives are financial instruments whose prices are
derived from the prices of other financial instruments.

Notes The subtle, but crucial, difference between derivatives and shares is that while
shares are assets, derivatives are usually contracts (the major exception to this are warrants
and convertible bonds, which are similar to shares in that they are assets). Well, we can
define financial assets (e.g. shares, bonds) as: claims on another person or corporation;
they will usually be fairly standardized and governed by the property or securities laws
in an appropriate country. On the other hand, a contract is merely an agreement between
two parties, where the contract details may not be standardized. Possibly because it is
thought that investors may be wary of the woolly definition of derivatives, one frequently
comes across references to “derivatives securities” or “derivatives products’’. These
“securities” and “products” sound fairly solid, tangible things. But in many cases there
terms are rather inappropriately applied to what are really contracts.

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