Let us assume that the price of agricultural product 'X' is $ 10,000 a ton in the market. You have contracted to purchase 100 tons at the rate of $ 9,500 per ton from the producer of that product. Now you can make profit on the sale of every ton of 'X'. Your total profit will be $ 50,000. Alternatively, the value of the agreement with producer is worth for $50,000. In this example, the product 'X" is an underlying asset and the agreement with producer is the derivative securities. In the same manner, contract can be made to purchase specified number of financial assets at specified price within predetermined time period. For example, you can promise to purchase 100 shares of Standard Chartered Bank Limited at $ 3,000 a share by July 2010 to your friend or you can promise to sell 100 shares at $ 2,950. The value of your promise to your friend and yourself depends on the market price of the share. Here, share of the bank is an underlying asset and the promise that you make is the derivative security ( an asset derived from underlying asset). We can conceptualize now that derivatives are the assets derived from other assets and in general, the value of such asset depends on the market price of the underlying assets. More specifically, in our example, share of Standard Chartered Bank Limited is underlying primary security and promises that you make to sell or purchase the share of this bank is derivative or synthetic securities.
Now we can define the derivatives. They are financial contracts whose value is linked to the price of an underlying commodity, asset, rate index or occurrence or magnitude of an event.The term derivative comes from how the price of these contract is derived from price of some underlying commodity, security or index or the magnitude of some events. Thus, this term is used to refer to the set of financial instruments that include futures, forwards, options, warrants, convertible ans swaps.
