Derivative instrument is one whose principal source of value depends on the value of something else, such as an underlying asset, reference rate or index.
First and foremost, a derivatives instrument is a contract, or agreement, between two counter parties. Unlike many market transactions where ownership of an underlying asset is immediately transferred from the seller to the buyer, a derivatives transaction involves no actual transfer of ownership of the underlying asset at the time the contract is initiated. Instead, a derivative contract simply represents a promise, or an agreement, to transfer ownership of the underlying asset at a specific price and time specified in the contract. The counter party that contracts to buy is said to have established a long position. A counter party that contracts to sell is said to have established a short position. Because of the bilateral nature of derivative contract, the value of contract depends not only on the value of its underlying asset but also on the creditworthiness of the counter parties to the contract.
Derivative contracts are characterised by the fact that for every long position there is a corresponding short position. Prior to the agreement of the long and short, the contract defining the terms of the future exchange for that asset did not exist. This means that the aggregate net value of derivatives in the economy is zero.
Another characteristic of a derivative contract is that it must be based on at least one 'underlying'. An underlying is the asset, reference rate, or index from which a derivative derives its principal source of value. In practice, derivatives cover a diverse spectrum of underlying, including stocks, bonds, exchange rates, interest rates, credit characteristics, weather outcomes, political events, or stock market indexes. Further, some derivatives can be based on multiple underlying. For e.g. the value of derivative may depend on the difference between a domestic interest rate and foreign interest rate.
Considering the above characteristics described above, derivatives can be defined as an instrument (contract) with all the following characteristics:
1. whose value changes in response to a change is specific underlying;
2. requires no/ little investment ; and
3. settled at a future date.
Following within the definition are several types of derivatives, including commodity derivatives and financial derivatives. A commodity derivative is a derivative contract specifying a commodity or commodity index as the underlying. For e.g., a gold forward contract specifies the price, quantity and date of future exchange of gold that underlies the forward contract.
A financial derivative is a derivative contract specifying a financial instrument, interest rate, foreign exchange rate, or financial index as underlying. For e.g. a contract to buy USD 1,000 in exchange of INR.
As we can see, when prudently used, derivative instruments offer an efficient mechanism for financial institutions, commercial enterprises, governments, and individuals to 'hedge' preexisting risk exposures; that is, to transfer risk from those who do not want to those who are willing to accept it for a price. In addition, derivatives serve as important 'price discovery' role, meaning that the prices of derivative instruments are useful for accurately assessing the future prospects of the underlying asset prices, reference rates, and price indexes from which derivatives contracts inherit their value.
Although derivative instruments offer many benefits to our economy, they also hold the potential for being misused. Warren Buffet refers derivatives as 'time bombs' and 'financial weapons of mass destruction'.
