Not everybody would be familiar with derivatives, but most would have heard about Futures and options and the terms calls and puts.

Going to the IPL match.

The purpose of this story is to give you an idea about the term called derivatives. The explanations provided at the end of the story make it clear.

Let us say you are planning to go to the UAE to watch the exciting IPL match to be held in Dubai next month and when you tried to buy the Rs. 3000 ticket online, you were disappointed to find they were all sold out

You approach a friend having contacts in Dubai. He gives you a letter addressed to his friend so that by showing this, he can purchase the ticket at Rs.3000 any time before the particular match.

As the date of the match drew near, tickets got sold at Rs 3,500 in the black market. Now, the reference letter you have with you has acquired a value, simply because you can purchase the ticket that is available at Rs 3,500, for Rs 3,000. In other words, the reference letter is now worth Rs. 500.

On the day preceding the match, you realize that the price of the ticket has gone up to Rs 4,500. The value of the reference letter you are holding goes up to Rs.1,500.

But, on the day of the match, you realize that you will not be able to witness the IPL match because of an important meeting at the office. You then decide to sell your reference letter to anyone willing to pay you Rs.1,500. You know that you have to do it without delay because the reference letter will not have any value once the match starts.

Now let us not worry about what happened next. We will instead discuss the reference letter you had with you in detail. Let us try to understand the features of the reference letter and go into the details.

• The letter gave you a right to buy the ticket at Rs 3,000.– Anytime before the start of the match. (When?)

• The letter attained value. - Black market price of the tickets went up. (How?)

• The value of the letter kept fluctuating because the price of the ticket in the black market kept rising. (Why?) Here you can see that it derived from the price of the ticket it represented.

• In financial terms, this letter is called a derivative instrument.

• A derivative instrument is a contract (the letter) the value of which derived from the price of an underlying asset (The match ticket)

FINANCIAL DERIVATIVES

The imaginary IPL match ticket was the derivative instrument. In reality, we do not find these kinds of ticket derivatives. Derivatives are used in the financial markets and are traded widely as a mechanism to guard against fluctuations in price.

To sum it up

• A Derivative is a term used in general.

• Derivative means derived from.

• Derivatives are financial instruments that are bought and sold.

• Futures and options also are types of derivatives.

• Derivatives incorporate a right. When someone buys a derivative, it means that the person has purchased the Right. While trading in the stock market, we can buy or sell shares. But in the case of derivatives, it is not the stock that is bought or sold. Instead, it is the right to buy or sell a share.

• One should note that the right could be The right to buy or the right to sell

• There is a time limit to this right to buy or sell, and one cannot hold on to it indefinitely. The exchange fixes the cut-off date before which one has to exercise the right or sell the right to another person.

• ‘Cost of buying a right’ is much less when compared to the actual price of a stock.

• Let us assume you bought the right to buy Infosys share at Rs.1010 per share for Rs.15 today. After a few days, the shares were trading at Rs.1200. You can now buy the share at Rs.1010 because you have purchased the right to buy Infosys share for this price. It is only natural that since the price in the cash market is Rs.1200, you can very well exercise your right to buy the share at Rs.1010 and sell it at Rs.1200. Your investment of Rs 15 has given you a return of Rs.175 ( Total cost = 1010 + 15) because the value of the underlying asset went up. (Infosys shares)

• Buying a derivative will not result in acquiring the share, but will result in ‘buying the right’ to buy or sell the shares.

• The buyer of a derivative gets a right over the asset. Here, in this case – shares. After some time, it could result in buying or selling this asset by the buyer.

• The asset may be anything and not confined to just shares. They could be commodities, currency, treasury bills, bonds, or indices of shares.

• A right becomes a derivative instrument when a transaction happens without the asset changing hands.

• There are different types of derivative instruments which are depending on the holder’s obligation.

• Futures, Options, Forwards, and Swaps are all types of derivative instruments.