Meaning of derivative, function of derivative, and their types
In this article, we are going to see the Meaning of derivative, the function of derivative, and their types.
Let’s start with an example,
One of my friend Sam is a big fan of the Indian Premier League (IPL). Every year he watches a Final Match in the stadium. This year also he decided to watch a match in the stadium, and when he tried to buy the ticket, he sees that the price of each ticket is 20,000 Rs and all of them sold out.
Luckily Sam has one friend (Tam) who is working in Cricket Association. Sam decided to approach his friend, and when he approached. Tam told him; I will provide you a letter while showing this letter you can buy the ticket for 20,000 Rs. Sam was happy, he took that letter and back to his home. As the date of the final match coming nearby, the ticket price increase from 20,000 to 22,000 Rs in the market. Although the ticket price is 22,000 Rs in the market, still Sam can buy the ticket for 20,000 Rs as he has the letter of his friend (Tam).
Due to the letter, Sam is in Profit of 2,000 Rs. In other words, the value of the letter is 2,000 Rs.
Before one day of the match, the ticket price increase from 22,000 to 25,000 Rs. Due to the poor health, Sam is unable to watch the final match in the stadium, and neither he sells the letter.
After the final match, the value of the letter becomes zero.
From this, we can understand that derivatives are a contract whose value derives from underlying assets.
Here letter is not a product, it’s a contract by using it, he can buy the ticket for the match.
The letter does not have direct value. The value of the letter totally depends on the ticket price.
Therefore, here underlying asset is the ticket, and the letter is a derivative whose price derives from the ticket price.
Derivatives contracts also have an expiry date. After the date, the value of the contract becomes zero.
There is various type of derivatives in our day-to-day life. For Example,
Here underlying assets is Milk and all of the above is derivative of Milk whose value depends on Milk.
If any underlying assets is a commodity, then it is known as commodity derivatives. Examples of commodity derivatives are Gold, silver, cotton, wheat, etc.
If any underlying assets are a debt institution, share, index, or currency, it is known as financial derivatives.
There are Four types of derivatives.