Derivative Instrument

  • Derivatives are financial instruments
  • They derive their value from an underlying asset price or index
  • Their primary purpose is to create rights and obligations to facilitate the transfer of risks between the party wanting to transfer and the party with the risk appetite willing to take on the risk
  • Usually used as a hedging instrument for managing risks

Definition of a derivative

  • A derivative is a financial instrument or other contract with all three of the following characteristics:
  1. its value changes in response to the change in a ‘underlying’;
  2. it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and
  3. it is settled at a future date

Examples of certain underlying

  • The following are some examples of underlying

– Interest Rate
– Security price
– Commodity price
– Index like Dow Jones, Sensex, Nifty
– FX rate
– Credit rating provided by an agency
– Non-financial variable like weather

Key features of derivative

  • Where the underlying is a non-financial variable, then it should not be specific to a party to be a derivative – else it would become an insurance contract
  • A derivative can have more than one underlying – for example a cross currency interest rate swap has a FX rate as one variable and interest rate as another variable

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