A derivative is a financial instrument:
(a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the 'underlying');
(b) that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and
(c) that is settled at a future date.
In India, different derivatives instruments are permitted and regulated by various regulators, like Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and Forward Markets Commission (FMC). Broadly, RBI is empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives. For regulatory purposes, derivatives have been defined in the Reserve Bank of India Act, as follows:
"Derivative" means an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called "underlying"), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time.
The term derivative indicates that it has no independent value, i.e., its value is entirely derived from the value of the underlying asset. The underlying asset can be commodities, securities, bullion, currency, livestock or anything else. In other words, derivatives means forward, futures, option or any other value of a specified real or financial asset or to an index of securities. The securities contracts (regulation) act 1956 defines derivative as under;
1. Security derived from a debt instrument, share, loan whether secure or unsecured, risk instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices of underlying securities.
A derivative instrument is a financial derivative or other contract with all three of the following characteristics:
1. One or more underlying, and
2. One or more notional amount or payments provisions or both.
Those terms determine the amount o the settlement or settlements.
It requires no initial net investment or an initial net investment is that smaller than would be required for other types of contract that would be expected to have a similar response to changes in market factors.
Its terms require or permit net settlement. It can be readily settled net by a means outside the contract or it provides for delivery of an asset that puts the recipients in apposition not substantially different from net settlement.
In general, from the aforementioned, derivatives refer to securities or to contracts that derive from another-whose value depends on another contract or assets. As such the financial derivatives are financial instruments whose prices or values re derived from the prices of other underlying financial instruments or financial assets. The underlying instruments may be a equity share, stock, bond, debenture, treasury bill, foreign currency or even another derivative asset. The price of the derivative is not the price of the financial derivative. For example, the value of a treasury bill of future contracts or foreign currency forward contract will depend upon the price or value of the underlying assets, such as Treasury bill or foreign currency. Due to this reason, transactions in derivative markets are used to offset the risk price changes in the underlying assets. In fact, the derivatives can be formed on almost any variable, for example, from the price of hogs to the among of snow falling at a certain ski resort.
The term financial derivative relates with a variety of financial instruments which include stocks, bonds, treasury bills, interest rate, foreign currencies and other hybrid securities. Financial derivatives include futures, forwards, and options, swaps etc. future contracts are the most important form a combination of cash market instruments or other financial derivate instruments. In fact, most of the financial derivatives are not revolutionary new instruments rather they are merely combinations of older generation derivatives and/or standard cash instruments.
The financial derivatives were also known as off-balance sheet instruments because no asset or liability underlying the contract was put on the balance sheet as such. Since the values of such derivatives depend upon the movement of market prices of the underlying assets, hence, they were recorded on the balance sheet. However, it is a matter of considerable debate whether off-balance sheet instruments should be considered for derivative is a debatable issue.
In brief, the term financial market derivative can be defined as a treasury or capital market instrument, which is derived from, or bears a close relation to a cash instrument or another derivative instrument. Hence, financial derivatives are financial instruments whose prices are derived from the prices of other financial instruments.
Features of financial derivative:
The basic features of the derivative instrument can be drawn from the general definition of a derivative irrespective of its type. Derivatives or derivative securities are future contracts which are written between two parties (counter parties) and whose value are derived from the value of underlying ideally held and easily marketable assets such as agricultural and other physical (tangible) commodities, or short term and long term financial instruments, or intangible things like weather, commodities price index to such contracts are those other than the original issuer (holder) of the underlying asset. From this definition, the basic features of a derivative may be stated as follows
1. A derivative instrument relates to the future contract between two parties. It means there must be a contract binding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short-term interest rate futures and long-term interest rate futures contract.
2. Normally, the derivative instruments have the value which derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. value of derivatives depends upon the value of the underlying instrument and which changes as per the changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related.
3. In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different.
4. The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial future contracts. The exchange – traded derivatives are quite liquid and have low transactional costs in comparison to tailor-made contracts.
5. In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the pay off. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differs from the payoff that their notional amount might suggest.
6. Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded respect of underlying assets.
7. Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to financial engineering.
8. Derivatives are most secondary market instruments and have little usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are exception in this respect.
9. Although in the market, the standardized, general and exchange-traded derivatives are being increasingly evolved, however, still there are so many privately negotiated customized, over the counter (OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of such derivatives.
10. Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a structured note whose coupon is tied to the performance of a particular currency pair.