Freeing of the economies and markets with resultant increased competition, need to survive
with thinner margins, increased volatility in all markets (commodity, finance and foreign exchange) have brought o focus the paramount importance the risk management assumes today in the business world. Derivatives have garnered greated attention recently as the instruments providing the needed leverage in managing almost all the risks attendant with business.
All business risks are ultimately measured in monetary terms. Understandably, the derivatives constructed to afford protection against these risks are financial instruments.
In the beginning the derivatives offered cover against prices of commodities, later they did so for financial assets like stocks and debts. A person who uses a derivative does so to protect himself against certain uncertainty in the future. The uncertainty may relate to the price of a commodity or a currency that is likely to prevail in a future period. For instance, an exporter who has a receivable in dollars due six months hence may firm up the exchange rate by entering into a forward exchange contract with his bank. The forward exchange contract is one of the derivatives available in the foreign exchange market. The risk of uncertainly about the exchange rate that will prevail in the market after six months hence is a set at rest by the rate obtained under the forward contract, under which the bank agrees to buy the dollars at a specific rate after six months, say Rs. 46 per dollar. The forward contract, therefore, provides a means of covering the exchange risk. However, whether the exporter has taken a right decision in going for a forward contract wil be known only on the due date. If the prevailing exchange rate in the foreign exchange market on the due date of the forward contract is Rs. 45, he would have gained by entering into the forward contract. He receives one rupee more per dollar than the case if no forward was booked. If the exchange rate in the market on the due date happens to be Rs. 47.50, he losed Rs. 1.50 per dollar by booking the forward contract.
Thus, the financial position of the derivative user, when it is put to use, may be better or worse than the position he would be in the absence of such action. When he enters into a derivative contract, he expects his position to be better by using a derivative than when he makes no use of it. But the evens prove otherwise too. The value of the derivative is therefore equivalent to the gain or loss arises from its use. Technically, the likely gain or loss from its use is known as the 'pay off'. The pay off of the forward exchange contract, in our example, depended on the exchange rate prevalent in the market on the due date. A derivative is therefore defines as
" a financial instrument whose value is depended upon (or is derived from) another fundamental asset "
The domain of derivatives has extended to many intangibles. For instance, there are electricity derivatives and weather derivatives. There are businessmen who feel the need for getting protection against the uncertainties relating to any of these variables. Another lot of enterprising businessmen see the opportunity for business by furnishing derivatives affording the needed protection. Therefore, newer and newer derivatives are being offered, depending upon the needs of the business. The definition of the term derivatives has also undergone change to reflect this emerging trend. Now it is more appropriate to define derivative as
" a financial instrument whose value depends on some other basic variable "
The following features of a derivative can be discerned from its definition:
- It is a financial instrument, giving rise to right and obligation in monetary terms;
- It is executable on a future date;
- Its value in dependent on the value of any other basic variable; and
- The value is determined as the gain or loss (pay off) to the buyer on the due date as compared to the open position.
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