DERIVATIVE INSTRUMENT

Derivative instrument:

                                                Derivative instrument is financial instrument which derives its value from other assets. The underplaying assets may be share, loan, or debt instrument.

                                                The value of derivative instrument is determined by the derivative contract.

For example:

                                You want to see a concert which shall be held next month. Each ticket costs is Rs 1000. All the tickets are sold and that time an acquaintance who is a part of the concert team gives a reference letter. Against which you will get the ticket at the rate of Rs 1000. The letter gives you the right to buy a ticket, it does not represent a ticket. The letter by itself has no market value.

                           

  At different time the value of reference letter depend on the value letter. If the value of ticket is Rs 1250 then the value of reference letter is Rs 250 (1250-1000) and if the value of ticket is Rs 1400 the value of reference letter will be 400(1400-1000).

From the above discussion we can derive 5 points:

1.       The value of the letter changes with changes in the price of the ticket.

2.       The letter derives its value from the value of the ticket. Hence it is called a “derivative” instrument.

3.       The letter gives you the right to buy the ticket.

4.       The “underlying asset” is the ticket.

5.       The letter does not constitute ownership. It is instead a promise to convey ownership.