The term derivative in the financial market indicates something that has no individual value, but it value is completely derived from the value of the asset. The asset in this case maybe, amongst the following and more:
Thus, derivative implies any of the following:
• Other hybrid contracts
These contracts would have the following common factors:
• Pre determined fixed time span
• Linking to the value of a specific real or financial asset; alternatively to an index of the securities.
Thus, essentially derivatives are financial instruments that draw their value from another financial price. The other financial price is termed as the underlying.
Take for instance, a farmer may want to enter a contract to sell his rice harvest on a future date, so as to curtail the risk of price fluctuations that may occur in the interim period – present to specified date. In such a situation the rate for such a contract will depend on the current spot price of rice.
This type of a transaction can occur in a rice forward market. In such a case the rice forward is the derivative, and rice on the spot market is the underlying. The most vital derivatives are futures and options.