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Introduction to Derivatives

Posted by Prashant Shah on May 7, 2011

The term ‘derivatives’ is used to refer to financial instruments which derive their value from some underlying assets. The underlying assets can be equities shares, bonds, T-bills, and notes, currencies, and even indices of these various assets, such as the Nifty 50 Index or BSE Sensex. The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another party. This includes changes in the price of the shares, currency or indexed. Impact of interest movements can also be reduced using derivatives.
 
Derivatives can also be defined as a financial instrument that does not constitute ownership but promise to convey ownership. Examples for the same are futures and options.
 
History of Derivatives:
 
The first “futures” contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a predetermined fixed price in the future), the farmers entered into contracts with the buyers. In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward contracts on various commodities.
 
Instruments:
  1. Forwards
  2. Futures
  3. Options
  4. Swaps

The most common type of derivative instuments are futures and options. While forward transactions are over the counter in nature.

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