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  • Print publication year: 2020
  • Online publication date: April 2020

10 - Financial Derivatives

Summary

Derivatives are financial weapons of mass destruction.

—Warren Buffett

Innovations have been a distinctive feature of global finance over the last half a century. Nothing has, however, been more overwhelming in its scope and breathless advance than financial instruments termed derivatives. Derivatives are not a new concept, having existed in rudimentary forms in the past; nevertheless, in recent times, they have taken the financial world by storm. No company or financial institution can claim to be working in the best interest of its stakeholders without fully taking advantage of derivatives to manage risk and maximize value.

India took its first hesitant step towards offering investors an opportunity to trade in derivatives in the year 2000 when the Securities and Exchange Board of India (SEBI) permitted the trading of equity-based index futures and options on the exchanges. Since then, terms such as index futures, swaptions, programme trading, synthetic cash, equity-indexed bonds, butterfly spreads, inverse floaters and portfolio insurance have become an integral part of the financial market lexicon. We may choose to be overwhelmed by, what to us are, as yet, esoteric terms. Or the excitement generated may lead us to a promising career in a field that has already become an integral part of the corporate life.

The future, of course, holds the greatest promise, and whether it is a career in traditional corporate finance, banking, investments or consultancy, expertise in derivatives would be crucial to success in the corporate sector.

The Concept

A derivative instrument is a financial contract whose pay-off structure is determined by, or derived from, the value of another asset.

A derivative is not an instrument in its own right; it has no direct value of its own but is based on some other instrument called the underlying. The value of the other variable determines the pay-off on the derivative. The pay-off, at any point in time, is a function of

  1. 1. the price at which the derivative transaction is undertaken and

  2. 2. the price in the cash market of the underlying variable upon which the derivative is based.

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