This type of security, which derives its value from an underlying asset, is called derivative security. The value of this security is determined by the value of the backing asset. Derivative securities primarily serve as tools for risk management, providing means to manage risks arising from price fluctuations.
These securities assist in decomposing risk into several components, including risks arising from interest rates, credit rates, and exchange rates, among others. Various types of derivative securities are available in India. For instance, the forex market utilises a type of derivative known as forwards.
Derivatives are financial instruments that derive their value from one or more underlying financial assets. The underlying instrument could be a financial security, a securities index, or some combination of securities and indexes. These financial instruments do not have intrinsic value.
They offer a hedge against the risk of owning assets that are subject to unexpected price fluctuations, such as foreign currencies, stocks, and government bonds.
Butter, for instance, is a simple example of a derivative – it derives its value from milk. The price of butter depends on the price of milk, which in turn is dependent on the demand and supply of milk.
In the Indian context, the Securities Contracts (Regulation) Act 1956 defines a “derivative” as:
- A security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument or contract for differences, or any other form of security.
- A contract that derives its value from the prices or index of prices of underlying securities.
Therefore, derivatives are specialized contracts to facilitate temporary for hedging, which is protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are an essential tool in risk management.