Derivatives and Underlying Assets
Products whose values are dependable and derived from the value of an underlying asset is called Derivatives.
The Underlying Asset could be Commodities, currencies, etc;
and the Product derived or dependable on it could be: Futures, Options, etc.
Commodities like Gold, Silver; which has value, are assets and the products whose value is derived and are dependable on these commodities (Gold, Silver, etc.) are derivatives like Futures, Options, etc. which are traded.
In Simple Terms:
You can consider Milk as an underlying asset which has a particular value say $3/liter. And the derivatives can be cured, butter or cheese which has their own value but are dependable and derived from the value of the milk. If the price of the milk increases then the value of curd, butter, cheese increases. And if in case decreases then vice-versa.
Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt.
The underlying asset can be equity (stock or index), currency, commodity, interest rates, and even weather, etc. So when the above underlying asset price changes, the derivatives price will also change.
Derivatives are financial contracts that derive their value from the causal asset. These could be stocks, indices, commodities, currencies, exchange rates, or the rate of interest. These financial instruments help you make profits by betting on the future value of the causal asset. So, their value is derived from that of the causal asset. This is why they are called “Derivatives”
The main purpose of derivatives is to transfer the price risk from one party to another; Risk is transferred to those who are willing to take it.
For example, A rice farmer spends money and effort in procuring land, buying seeds, manure, is dependent on water supply and many other factors to produce rice.
If he spends $1 per 5kg in producing rice, he obviously wants to sell his produce at a price higher than $1 per 5kg.
But what if after 3 months (when finally produce will be out) price of rice is less than $1 per 5kg?
So today, for protection, the farmer may wish to sell his harvest at a future date for a pre-determined fixed price (more than $1 per 5kg) to eliminate the risk of change in prices by that date.
He enters into a contract for selling his produce at $3 per 10kg, 3 months from now. Such a transaction is an example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the “underlying”.