What are Derivatives and how do they work?

What are Financial derivatives?

Derivatives are financial instruments which derive its value from the underlying asset.

Feeling quite a heavy right? No worries. Let’s understand Financial derivatives through an example. Let’s assume that we all are very much fond of music, who won’t be, right? So there is a big music concert-going to happen in town by a famous musician. The tickets are sold at Rs.100. Your friend who is in that music troop has given you a discount coupon, which you can use to purchase the same tickets at Rs.75. So what is the benefit you are getting from this discount coupon? that’s right, you save Rs.25. That is the value of that coupon. This discount coupon in our example is the derivative because the value of the discount coupon depends on the value of the ticket As and when the ticket prices rise, value of your discount coupon also increases. Imagine that as the date comes closer, the ticket value goes up to Rs.150. Then the value of our derivative, which is the discount coupon, goes up to (150-75) Rs.75. This goes to say that though the actual ticket value is Rs 150 because you have a discount coupon you can get the same ticket for Rs.75, hence the value of the discount coupon is Rs.75 Say the concert got cancelled as the musician got sick. Then no one will be interested in our discount coupon, because the concert is not happening. and hence the value of the discount coupon will be zero.