Investment Banking

Derivative – Basics – understand the definition from kids’ point of view

When you were kid, you were first taught the alphabets. Nothing in literature falls out of alphabets. However, after completing PhD in literature you understand that you know nothing about literature.

Similarly, here is the ABCD of Derivatives.

Definition: Derivative is a financial instrument that derives its value from the value of the “underlying” asset.

Derivative is a security. It is a contract.

Let’s understand jargons in definition one-by-one.

Financial instrument: Every profession has its unique tools and instruments. For example, take Music, you see instruments like Guitar, Drum, Piano etc. Same way in Finance there are various instruments to effectively perform certain kind of financial activities. One of these instruments is called “Derivatives”.

Assets: 4 types of assets for derivatives are:

  1. Equities
  2. Fixed Income Securities / Interest Rates
  3. Currencies
  4. Commodities

Note here that Interest Rates (IR) are exceptions. They are not assets in itself but linked to an asset like Fixed Income Securities.

So, if you hold an asset, say, gold (commodity) you may benefit from selling it at an increased price.

However, you and many others, without having the gold itself, can have a derivative on gold, which is essentially a security or contract you can benefit depending on the performance of Gold price and terms of your contract. Key thing to note here is that you do not need to hold the asset to have a derivative on it. In 2008 debacle, exactly this happened. All kinds of Investors had derivatives on same asset. When price of asset plummeted not only the asset holder lost the asset but everyone who had derivatives (to be benefitted on increasing price) also lost their money.

In next article, we will see types of derivatives. We would love to hear your views and comments on article. Feel free to share this article with anyone!

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