Financial Derivatives

Introduction:
Derivative is a security or a financial asset which derives its value from some specified underlying asset. A derivative does not have any physical existence but emerges out of a contract between two parties. It does not have any value of its own but its values, in turn, depend on the value of other physical assets which are called the underlying assets. These underlying assets may be shares, debentures, tangible commodities, currencies or short term or long term financial securities, etc.

Features of the Financial Derivatives:
Some of the basic features of derivatives are numerated below:
1. As the derivatives are not physical assets, the transactions in the derivatives are settled by the offsetting/squaring transaction in the same derivative. The difference in value of the derivative is cash settled.
2. There is no limit on number of units transacted in the derivative market because there is no physical asset to be transacted.
3. The derivative markets are usually the screen based computerised exchanges as against the trading markets for physical assets.
4. Derivatives are only secondary market securities and cannot help in raising funds to a firm. In fact, derivatives arise only when the shares and debentures are already issued by the companies.
5. The derivative market is quite liquid and transactions can be affected easily.
6. The derivatives provide a hedging of price risk of financial transactions over a certain period. It is a contract to be settled in future, by cash payment of difference in price. A derivative contract must be distinguished from the underlying assets though the value of the derivative and the underlying assets are definitely related.