Saturday, June 23, 2012

Introduction of Derivatives


The origin of derivatives can be traced back to the need of farmers to protect themselves against
fluctuation in the price of their crop. From the the time it was sown to the time it was ready
for harvest, farmers would face price uncertainty. Through the use of simple derivative products,
it was possible for the farmer to partially or fully transfer price risks by locking–in asset prices.
These were simple contracts developed to meet the needs of farmers and were basically a means
of reducing risk.
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A farmer who sowed his crop in June faced uncertainty over the price he would receive for his
harvest in September. In years of scarcity, he would probably obtain attractive prices. However,
during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly
this meant that the farmer and his family were exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would face a price
risk – that of having to pay exorbitant prices during dearth, although favourable prices could be
obtained during periods of oversupply. Under such circumstances, it clearly made sense for the
farmer and the merchant to come together and enter into a contract whereby the price of the grain
to be delivered in September could be decided earlier. What they would then negotiate happened
to be a futures–type contract, which would enable both parties to eliminate the price risk.

A derivative is a product whose value is derived from the value of one or more underlying
variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their
harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction
is an example of a derivative. The price of this derivative is driven by the spot price of wheat
which is the “underlying” in this case
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