Financial Derivatives – Meaning & Concept

A "Derivative" is something that has no value of its own. It derives its value from something else.

1. Definition

"A Derivative is a financial instrument whose value is derived from an Underlying Asset."

• Analogy: Curd (Dahi) is a derivative of Milk. If Milk price rises, Curd price rises. Curd has no independent value without Milk.
• In Finance: The "Milk" is the Underlying Asset (e.g., Gold, Stock, Dollar), and the "Curd" is the Derivative Contract.

2. The Concept of Underlying Asset

The asset from which value is derived is called the Underlying.

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3. Why do they exist?

Originally, they were created for Farmers to protect against crop failure or price drops (Hedging). Today, they are used by everyone from huge banks to small traders.

4. Exam Notes: Writing the Answer

Question: "Define Financial Derivatives. Explain the concept of Underlying Asset." (5 Marks)

Answering Strategy:

1. Definition: Quote the proper definition ("Derived from underlying...").
2. Examples: Write Gold -> Gold Futures, Reliance Share -> Reliance Call Option.
3. Key Phrase: "No independent value" – examiners look for this phrase.

Summary

• Derivative: A contract between two parties.
• Value: Linked to the price of the Underlying.
• Relationship: Direct positive correlation (usually).

Quiz Time! 🎯

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