This type of security derives its value from the underlying asset. The value of the backing asset determines the value of the derivative security. A derivative security is mainly used for the purpose of risk management. The risks arising out of price fluctuation may be managed with the help of derivative securities.
These securities help in breaking down the risk in several components, including risk arising out of interest rate, credit rate and exchange rate risk, etc. There are several types of derivative securities available in India. For example, the forex market uses a type of derivatives called forwards.
Derivatives are financial instruments whose value is derived from one or more underlying financial asset. The underlying instrument could be financial security, a securities index, or some combination of securities and indexes. Derivatives are financial instruments that have no intrinsic value.
They hedge the risk of owning things that are subject to unexpected price fluctuations, for example, foreign currencies, stocks, and government bonds.
A simple example of derivatives is butter, which is a derivative of milk. The price of butter depends upon the price of milk, which in turn depends upon the demand and supply of milk.
In the Indian context, the Securities Contracts (Regulation) Act, 1956 defines “derivative” to include:
- 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.
- A contract which derives its value from the prices or index of prices of underlying securities.
Therefore, derivatives are specialized contracts to facilitate temporarily for hedging, which is protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are an essential tool in risk management.