What are derivatives? Overview, Types, and Their Uses

KeyInghts 

1. Derivatives are agreements that depend on the future prices of things like crops or stocks. They let people manage risk or try to make a profit without actually owning the asset.
    
2. The four main types are forwards, futures, options, and swaps. Some are private and tailored to specific needs, while others are standard contracts traded on markets. These give people either flexibility or a set obligation.
    
3. People use derivatives for hedging, speculation, arbitrage, and leverage. They help farmers, investors, and businesses lock in prices, try to make a profit, or control large trades with less money up front.

Financial contracts known as derivatives derive their value from other sources, such as stocks, gold, or even the state of the weather. 

Example:

Let's say Shikhar wants to purchase a rare alien toy, but the current price of ₹1,000 prevents him from doing so. He strikes a bargain with the storekeeper rather than purchasing it today:

• Shikhar pays ₹100 today to lock the price.
• After 3 months, he can buy the toy for ₹1,000, even if the price goes up to ₹1,500.
• If the price falls to ₹800, Shikhar can choose not to buy it, losing only ₹100.

Below is a table to explain this easily:
 

This table helps you understand how derivatives work.

People can manage risks or bets on future prices with the use of derivatives. Everything about them is explained in plain English in this article.

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How Do Derivatives Work?

Financial transactions based on the future value of commodities, such as gold, stocks, or crops, are known as derivatives. People agree to trade the item later at an agreed-upon cost rather than purchasing it.

How It Works in Simple Terms

1. Two people agree on a future trade at a price decided today.
2. The deal’s value changes based on the actual price of the item later.
3. No need to own the item, just bet on its price movement.

Example 1: Mayank the Farmer (Futures Contract)

• Mayank grows wheat and expects a harvest of 1000 kg in 3 months.
• Current price: ₹20 per kg.
• Worried about a price drop, he sells a futures contract at ₹20 per kg for 1000 kg.
• After 3 months:
  • If the price falls to ₹15 per kg, Mayank still gets ₹20 per kg (saves ₹5,000).
  • If the price rises to ₹25 per kg, he misses extra profit but avoids risk.

Example 2: Amber the Investor (Call Option)

• Amber thinks XYZ stock (₹100 today) will rise in 2 months.
• She buys a call option (right to buy at ₹110) for ₹5 per share.
• After 2 months:
  • If the stock hits ₹130, she buys at ₹110, sells at ₹130, and profits ₹15 (₹130 - ₹110 - ₹5).
  • If the stock stays at ₹90, she doesn’t buy, losing only ₹5 (the option fee).

Understanding Through a Table:

Futures are obligations; options are rights to buy or sell.
 

This table helps compare the effects of different derivatives.

People can use derivatives to fix prices or place bets on future values without actually owning the product. Amber uses them to profit from changes in stocks, while Mayank uses them to safeguard the price of his crops.

Types of Derivatives

Derivatives are specialised financial contracts based on the future price of an asset, such as crops, gold, or company shares. There are four main types, and each one helps people control risk or uniquely generate income.

The 4 Main Types of Derivatives: (with example)

1. Forward Contracts
   • Private deals between two people/companies
   • Custom terms (amount, price, date)
   • Example: Rahul agrees to buy 100kg of coffee beans at ₹200 per kg from a farmer after six months, regardless of the market price.

2. Futures Contracts
   • Standardised deals traded on exchanges
   • Must buy/sell at the set price on the set date
   • Example: Rahul buys a futures contract for 10 Reliance shares at ₹2,500 per share to be purchased in 3 months.

3. Options Contracts
   • Choice to buy (Call) or sell (Put) at a fixed price
   • Pay a small fee (premium) for this right
   • Example: Rahul pays ₹50 per share to get the option to buy TCS shares at ₹3,000 within 2 months (but can back out if unprofitable).

4. Swap Contracts
   • Exchange one type of payment for another
   • Common in loans/currencies
   • Example: Rahul's company swaps its floating interest rate loan (currently 8%) for a fixed 7% rate with another company.

Comparison Table:

Custom private deals compared to standardised, tradable public contracts.
 

This table shows key differences between derivative types.

Futures, options, swaps, and forwards all benefit individuals and companies in various ways, from lowering loan risks (interest rate swap) to locking in prices (Rahul's coffee deal).

Rahul's examples are used in this section to clearly explain the four different types of derivatives. Whether for farmers, investors, or businesses, each kind meets specific needs.

Also Read - What Happens If You Default On A Personal Loan? Legal & Financial Consequences?
 

Uses of Derivatives

Financial instruments known as derivatives assist individuals in controlling risks or profiting from shifts in prices. They are employed for speculation, protection (hedging), and leverage (gaining more control with less money).

Why People Use Derivatives:

1. Hedging (Risk Protection)
   • Farmers, businesses, and investors use derivatives to lock in prices and avoid losses.
   • Example: Karan owns a petrol pump. He buys oil futures at ₹5,000 per barrel to protect against rising prices.
      
2. Speculation (Betting on Prices)
   • Traders use derivatives to profit from price movements without owning the actual asset.
   • Example: Karan buys a call option on HDFC Bank shares (₹1,500), hoping the price will rise.
      
3. Arbitrage (Risk-Free Profit)
   • Taking advantage of price differences in different markets.
   • Example: Karan buys gold at ₹6,000 per gram in Mumbai and sells it for ₹6,100 per gram in Delhi.
      
4. Leverage (More Gains with Less Money)
   • Derivatives allow controlling larger investments with small capital.
   • Example: With ₹10,000, Karan can trade stocks worth ₹1,00,000 using futures.

How Karan Uses Derivatives (Table)
 

Hedging reduces risk; speculation, arbitrage, and leverage seek profits.
 

This table shows how derivatives serve different financial needs.

Derivatives help people like Karan protect against risks, make profits, and trade smarter. Whether for business safety or investment gains, they are powerful tools in finance.

Conclusion

Derivatives help people better manage their money by acting as innovative betting tools or financial safety nets. Traders use them to capitalise on price shifts, farmers to lock in crop prices, and businesses to protect against rising expenses. 

They enable you to manage large transactions with little financial outlay, but if not used properly, they can be dangerous. Derivatives are useful for a variety of financial purposes, including hedging against future price fluctuations, generating profits, and identifying price discrepancies in markets. 

Whether you're an investor, business owner, or farmer, knowing them helps you make better financial decisions. Just keep in mind that, despite their strength, they must be handled carefully to prevent significant losses.

FAQs

Do I need a lot of money to trade derivatives?

No! Derivatives allow you to control large amounts with little money (called leverage). However, remember that small investments can lead to either big gains or big losses.

What’s the difference between futures and options?

Futures are a promise to buy/sell later at a fixed price. Options give you the choice (not obligation) to buy/sell, and you pay a small fee for this right.

Can derivatives make me rich quickly?

Some traders profit fast, but many lose money just as fast. They’re tools, not magic; knowledge and caution matter more than luck.

Who uses derivatives in real life?

Farmers, airlines (to control fuel costs), big companies, and stock traders all use them for different needs, like price stability or investments.

What’s the biggest risk with derivatives?

Leverage is the double-edged sword; it multiplies gains but also losses. If prices move against you, you could owe more than you invested.

Are derivatives only for experts?

Beginners can use simple derivatives (like basic options), but it’s wise to learn first. Complex ones (like swaps) are for pros.

Where can I trade derivatives?

In stock markets (like NSE/BSE) or through brokers. Always check fees, rules, and risks before starting.
 

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