What are Derivatives?

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The term Derivatives in its literal sense indicates that it has no independent value, i.e., its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else.

 In other words, Derivative means a forward, future option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

 Derivatives have been associated with a number of high-profile corporate events that roiled the global financial markets over the past two decades. To some critics, derivatives have played an important role in the near collapses or bankruptcies of Barings Bank in 1995, Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers in and American International Group (AIG) in 2008. Warren Buffet even viewed derivatives as time bombs for the economic system and called them financial weapons of mass destruction (Berkshire Hathaway Inc (2002)).

 But derivatives, if “properly” handled, can bring substantial economic benefits.

  • These instruments help economic agents to improve their management of market and credit risks. 
  • They also foster financial innovation and market developments, increasing the market resilience to shocks.
  • The main challenge to policymakers is to ensure that derivatives transactions being properly traded and prudently supervised. 
  • This entails designing regulations and rules that aim to prevent the excessive risk-taking of market participants while not slowing the financial innovation aspect. And it also calls for improved data quantity and quality to enhance the understanding of derivatives markets. 

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