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What are Derivatives?

Chapter 1

What are Derivatives?

What are Derivatives?

Chapter 1

What are Derivatives?

A financial derivative is a contract between two parties, where the instrument under trade, derives its value from the price of the underlying asset, hence the name “derivative”.

Derivative means: it is a derived product

For eg. Cheese, butter are derivatives of milk and they derive their value from the pricing of milk. So, if milk prices move higher, it is highly likely that cheese and butter may also get expensive. But would the pace of price increase be at the same pace or at a different one, that’s not a certainty. Derivatives are used as instruments to mitigate price risk through hedged transactions. The history of derivatives dates back centuries and has spanned varied civilisations, dating back to the Mesopotamian era.

The price behaviour of the financial derivative may be linear or non-linear to the price changes of the underlying asset. Examples of derivative contracts include futures, options, forwards, swaps etc. The examples of underlying asset include commodities like metals, agricultural produce, energy and financial assets. Financial assets include equities, bonds and forex. Derivatives may be exchange traded or over the counter (OTC).

The derivatives market in India has witnessed a stupendous growth. Many derivative contracts were also launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are:

    • Increased fluctuations in underlying asset prices in financial markets.
    • Globally interlinked markets
    • Advent of latest technology in communications has helped in reduction of transaction costs.

Types of Derivative contracts


Forward contract is a type of financial derivative contract which is not traded on an exchange but is an OTC (over the counter) contract between two parties, to buy or sell the underlying asset at a predetermined price and on a predetermined date. Since it is an OTC contract, it is customisable to the client needs and makes them suitable instruments for hedging. But forward contract entails variety of risks. Forward markets worldwide are affected by the following risks:

    1. lack of centralisation of trading
    2. liquidity risk
    3. counterparty risk

In India, OTC Forward contracts in FX markets are a mode of hedging and one of the ways, remittances/payments are hedged, is using forward contracts.


A futures contract is similar to a forward, but the transaction happens on a regulator recognised (SEBI in India) exchange rather than OTC. Indeed, we may say futures are nothing but exchange traded forward contracts.


An Option is a contract that gives the Buyer right, but not an obligation, to buy or sell the underlying asset on or before a pre-determined date and at a pre-determined price. While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, provided the buyer exercises the right.

Contract with Right to Buy =  Call Option

Contract with Right to Sell = Put Option

Also, Swaps

A swap is an agreement made between two parties to exchange cash flows in the future according to a pre-determined/pre-decided formula. Usually, the principal does not change hands. Each cash flow represents one leg of the swap. One cash flow is fixed, while the other is dependent on or based on a floating currency rate, benchmark interest rate, or index price. Swaps help market participants associated with volatile interest rates, currency exchange rates and commodity prices to mitigate their risk, or otherwise called hedged transactions.

The discussion ahead shall be focused on, futures and options, while swaps and forwards are derivatives which are beyond the purview of current discussion.


What are Derivatives?

Financial derivatives are instruments or contracts which derive their value from the underlying like an index, Nifty or F&O stocks. They may be linear by nature of price action or non-linear.

What are the types of derivatives?

There are a large set of derivatives traded globally, ranging from forwards, futures, options, swaps, swaptions etc. But the financial derivatives of interest to Indian capital markets are primarily futures and options.

What is the difference between derivatives and shares?

Financial derivatives are instruments or contracts which derive their value from the underlying like an index, Nifty or F&O shares or commodities or forex etc. They may be linear by nature of price action or non-linear as compared to the price of underlying.

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What are the advantages of derivatives?

Financial derivatives are leveraged products which allow for good returns and need to be handle with care, as potential of large losses is also possible if discipline and prudence is absent with the trader.

Are derivatives low risk?

Derivatives being leveraged products aren’t low-risk products.

Is it better to invest in derivatives rather than equity?

Derivatives or financial derivatives, especially, are leveraged products, where the potential of profit or loss is manifold as compared to the equity cash market. So, traders have to be aware of the risks which financial derivatives entail. So, awareness of the risk factors is important and disciplined trading can work wonders for derivative traders.

What are derivatives in finance?

Financial derivatives are instruments or contracts which derive their value from the underlying like an index, Nifty or F&O stocks. They may be linear by nature of price action or non-linear.