Page 7 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes
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Caution The word 'derivatives' originated in mathematics and refers to a variable that has
been derived from another variable. For example, a measure of distance in kilometers
could be derived from a measure of distance in miles by dividing by 1.61, or similarly a
measure of temperature in Celsius could be derived from a measure of temperature in
Fahrenheit. In financial sense, a derivative is a financial product which had been derived
from a market for another product.

1.1 Meaning and Definitions of Derivatives

A derivative security is a financial contract whose value is derived from the value of something
else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index
of prices.

Various Definitions of Derivatives

1. Derivatives are financial contracts whose value/price is dependent on the behaviour of
the price of one or more basic underlying assets (often simply known as the underlying).
These contracts are legally binding agreements, made on the trading screen of stock
exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate,
bond, rupee dollar exchange rate, sugar, crude oil, soyabean, cotton, coffee and what you
have.

2. Thus, a 'derivative' is a financial instrument, or contract, between two parties that derived
its value from some other underlying asset or underlying reference price, interest rate, or
index. A derivative by itself does not constitute ownership, instead it is a promise to
convey ownership.
The Underlying Securities for Derivatives are:
(a) Commodities (Castor seed, Grain, Coffee beans, Gur, 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 the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines "derivative"
to include:
1. 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;

2. A contract which derives its value from the prices, or index of prices, of underlying
securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives
is governed by the regulatory framework under the SC(R)A.

A very simple example of derivatives is curd, which is derivative of milk. The price
of curd depends upon the price of milk which in turn depends upon the demand and supply of
milk.

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