Concept of Derivatives

A derivative is a financial instrument, essentially a contract, whose value is derived from the value of another asset or variable. This underlying asset or variable can be anything from a stock or bond to a commodity price, an interest rate, or even a market index. The crucial point is that the derivative itself doesn't have intrinsic value; its worth is entirely dependent on the fluctuations of the underlying. The value of a derivative at a point in time is determined by the underlying.

Think of it like this: a derivative is like a side bet on the outcome of a race. The race itself involves the underlying asset (e.g., the price of a stock), and the derivative is an agreement between two parties about what will happen based on the race's result (the stock's price movement).

Key Features of a Derivative Contract:

• Underlying: The asset or variable that determines the derivative's value.
• Contract Terms: Specifies the agreement, including the underlying, price, quantity, and settlement date.
• Settlement Date (Maturity): The future date when the contract is settled.
• Contract Size: The quantity of the underlying involved in the contract.
• Zero Initial Value: At the beginning, neither party pays anything; the contract is structured to have zero value to both parties initially.