Derivative for Dummies: By a Dummy

Yes, it’s for Dummies and by a dummy on Derivatives. So here’s what lil’ bit of Derivatives I understand(or pretend to..). Read on….

Derivative is a product whose value is derived from the value of one or more basic variables, called underlying. The underlying asset can be equity, index, foreign exchange (forex), commodity or any other asset. Derivative products initially emerged as hedging devices against fluctuations in commodity prices.

In India, BSE created history on June 9, 2000 by launching the first Exchange traded Index Derivative Contract i.e. futures on the capital market benchmark index – the BSE Sensex. The exchange commenced trading in Index Options on Sensex on June 1, 2001. Stock options were introduced on 31 stocks on July 9, 2001 and single stock futures were launched on November 9, 2002. September 13, 2004 marked another milestone in the history of Indian Capital Markets, the day on which the Bombay Stock Exchange launched Weekly Options.

Types of Derivatives:
Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts, such as futures of the Nifty index.

Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price.

Facts: The daily trade of commodities futures market is expected to rise by another Rs 5000 crores from the Rs 15000 crores being traded currently.

With increasing interest from investors, the basket of 120 commodities currently being traded is likely to touch 250 by 2007-08.

Options offer three significant benefits: Versatility; High Leverage and Risk Management. (I bet I didn’t understand this, but I’ll pretend I did)

Last Word: Warren Buffet sees derivatives as “time bombs” and a weapon of mass destruction!!

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