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Basics of Derivatives

Introduction to Derivatives

 

What are derivatives?

The term "Derivatives" originates from the term "Derive" of English language, which as per Oxford dictionary means obtains something from (a specified source).

 

Let us take a very simple example to understand what Derivatives are:

 

Let us assume that there is a farmer, who works throughout the year in his farm and produces wheat. Currently it is the month of March and the price of wheat in the spot market where the farmer sells his produce is ₹10/kg. The total cost of production of wheat for the farmer including fertilizer, seed and his effort is ₹6/kg.

 

However, the wheat in the farmer's land will mature in the month of June, 3 months from today. Thus, he is worried that if there is good rainfall leading to June, wheat from all the farmers will simultaneously hit the market and because of this the price of wheat might go down to ₹8/kg and this will lead to a profit of only ₹2/kg for the farmer.

 

He is also aware that, leading to June, the overall rainfall might not be that good, and the overall supply of wheat hitting the market could be less and this can lead to the price of wheat going up to ₹12/kg. Now, since his farm is well irrigated, he will produce the desired quantity of wheat and sell at the price of  ₹12/kg to generate significant profits.

 

In both the scenarios, what the farmer faces is the price volatility risk even though in the latter case, the price variability is favourable to the farmer but he is more worried about the first case where his profitability will shrink due to fall in price.

 

On the other hand, let us assume that there is a company ITC Ltd., which uses wheat throughout the year and produces flour in the brand name 'Ashirwad', as you all know.  

 

Currently it's the month of March and the price of the wheat in the spot market from where ITC buys is ₹10/kg. The overall cost for ITC to process the wheat into Flour (including packaging and marketing) is ₹4/kg. ITC has already tagged the packets in which it sells the flour at ₹16/kg, thus realizing a profit of  ₹2/kg.

 

However, what ITC is aware of is that, in the month of June, if the overall rainfall is not that good, then the supply of wheat hitting the market could be less and this can lead to the price of wheat going up to ₹12/kg. This will lead to an increase in cost for ITC and shrink its profitability to zero. 

 

ITC cannot just simply raise its price of the flour. The reason behind this is that Ashirwad flour is a branded product. There is a huge cost involved in even raising the price and it is a consumer centric product. If ITC raises the price frequently, consumers will shift to a different brand or non-branded flour.

 

ITC also knows that if there is good rainfall, wheat from all the farmers will simultaneously hit the market and because of this the price of wheat might go down to ₹8/kg. In this case it would lead to a profit of  ₹4/kg.

 

In both the scenarios, ITC faces price risk, even though in the latter case, the price fluctuation is favourable to ITC but it is more worried about the first case where its profitability will shrink due to fall in price.

 

Now the important thing to note is: The farmer faces the risk of losing money if the price of wheat goes down; and ITC faces the risk of losing money if the price of wheat goes up. Thus, both of them (farmer and lTC), in order to avoid this risk and to reduce the price uncertainty, enter into a contract, which says that:

 

 

This contract between farmer and ITC to buy and sell fixed quantity wheat at a specific price and at a specific date is called a DERIVATIVE CONTRACT. 

 

According to the contract, the farmer in June is entitled to sell wheat at  ₹11/kg, no matter what the price of wheat is in the spot market, and ITC has to buy the wheat at ₹11/kg, whatsoever the price of wheat be in the spot market.

 

Thus, by the virtue of this contract both the farmer and ITC have eliminated the price risk. This is precisely what the use of derivatives is or that is what derivatives are.

 

Derivatives are contracts in which two parties enter into a contract in order to eliminate or hedge their risk. It could be price risk or risk of any kind of uncertainty.

 

In the Indian context, the Securities Contracts (Regulation) Act, 1956 (SCRA) defines "derivative" as-

 

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 that derives its value from the prices, or index of prices, of underlying securities.

 

The first definition says that the derivative contract for wheat between farmer and ITC is derived from the underlying asset, which is 1000 Kgs of wheat.

 

The second definition says that the value of the wheat contract depends on the value or price of the wheat, which is the underlying asset in the spot market.

 

This means that in the spot market, say in April, even if the price of wheat goes up to ₹13/kg, the person holding this contract still has the right to buy wheat only at  ₹11/kg. Thus, the value of this contract, which previously was only ₹11,000, has now increased to ₹13,000.

 

A derivative is a financial contract with a value that is derived from an underlying asset. Derivatives have no direct value of themselves - their value is based on the expected future price movements of their underlying asset. 

 

The underlying instruments can be anything such as bonds, commodities, currencies, interest rates, market indexes and stocks. So, there are different types of financial derivatives available in the market. Let us discuss them in the next section. 

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