Definition of Derivatives

Derivatives are financial instruments whose value is derived from an underlying asset or group of assets. These assets can include stocks, bonds, commodities, currencies, interest rates, or market indices. The value of derivatives changes in response to the fluctuations in the price of the underlying asset. Derivatives serve as risk management tools, investment vehicles, and speculative instruments in financial markets.

Example: A futures contract on gold is a derivative because its value is linked to the price of gold. If the price of gold increases, the value of the futures contract will also rise.

Features and Uses of Derivatives

Features of Derivatives

Derivatives possess several key features:
a) Leverage: Derivatives enable investors to gain exposure to a larger position in the underlying asset with a smaller upfront investment.
b) Flexibility: Derivatives offer a wide range of strategies to hedge risk or speculate on price movements.
c) Transfer of Risk: Hedgers can use derivatives to transfer specific risks to other parties.
d) Price Discovery: The prices of derivatives can provide valuable information about market expectations and sentiment.

Uses of Derivatives

Derivatives have various uses, such as:
a) Hedging: Investors use derivatives to protect themselves against potential losses from adverse price movements in the underlying asset.
b) Speculation: Traders speculate on future price movements to earn profits from the changing value of derivatives.
c) Arbitrage: Arbitrageurs exploit price discrepancies between derivatives and their underlying assets to make risk-free profits.

Comparison of Linear and Non-Linear Derivatives

Linear Derivatives

Linear derivatives have a linear relationship with the underlying asset’s price, meaning the value of the derivative changes proportionally to the change in the asset’s price. Common linear derivatives include forward contracts and futures contracts.

Example: A linear derivative could be a forward contract on a stock, where the value of the contract increases linearly with every $1 increase in the stock price.

Non-Linear Derivatives

Non-linear derivatives, on the other hand, have a non-linear relationship with the underlying asset’s price, resulting in complex payoffs. Options contracts are a common example of non-linear derivatives.

Example: A call option on a stock is a non-linear derivative. If the stock price increases significantly, the call option’s value may increase exponentially.