Basic Concept of Derivatives

The concept of derivatives has its origins in the mechanisms farmers take to insure themselves against crop price volatility due to external factors.

For example, a farmer who sows his crops in a particular month, can never be certain what they will fetch during the harvest a few months later. Prices could vary because of shortage or oversupply arising out of climatic conditions, competition and even socio-political factors. The merchant buying the farmer’s produce is also exposed to similar risks.

So, to limit their losses and manage the associated risk, the farmer and the merchant enter into a forwards contract that binds them to trade the produce for a price agreed at the time of sowing, but which would become payable only at the time of harvesting, naturally at a premium/discount to the current price.

In a sense, both the farmer and the merchant share, and transfer risks between themselves. In the event of the crop’s prices crashing by harvest time, the farmer ensures his downside will be capped, although the merchant’s risk will be greater – to the extent the prices actually fall. Conversely, if prices rise, the merchant won’t have to pay the exorbitant rates of the day, and hence cap his outgo, although the farmer will lose out on the prospect of making greater gains.

Another way of looking at it, is someone wants to give his wife jewellery on her birthday a few months later. By the spot market concept (regular stock market trades), he would pay, say, Rs 10,000 for the ornament then and there, and take it home with him. But if the derivatives route was available, he could enter into a contract with the jeweller, promising to buy the ornament one, two or three months later, at a mutually agreed premium over the current price, say, Rs. 10,200.

In that way, the buyer wouldn’t have to commit funds immediately, and yet insure himself against future price fluctuations. Likewise, the jeweller, while capping the possibility of greater future gains, limits his downside should prices crash in the interim.

Of course, with forwards there is always the risk of one party not honouring the deal. Which led to the concept of futures. Futures is a standardized, exchange-traded forwards contract, where both parties have to mandatorily honour the agreement. Futures along with options constitute the derivatives segment.

You will see, therefore, that derivatives are a kind of insurance against future unknowns.