Today I am going to explain what is derivatives in a very simple example and why it is important and why a MBA finance should know about it .
Let’s start , “Derivatives are the financial instruments which derives their value from some underlying assets”. The underlying Assets could be equities (shares) , debt (Bonds , Treasury bills ) currencies etc . Now to understand better let’s take a example :- There was a person name Kumar who is a farmer and produce rice. He know that he will produce 10 bags of rice and want to sell them in the market 1 year from now . He knows that he will spend Rs 30 in order to produce each bag of rice . So his total investment is Rs 300 .But now he is worried that if there is a decline in price of rice in the future then he is not going to get much money for his bag of rice . So to protect his business Kumar meets a investment broker and enters a business contract with him . Consider you are the investor who has sent your broker to Kumar , you may think that the price of rice will go up in the future. So , you tell your broker to agree to pay Kumar Rs100 for each bag of rice one year from now , irrespective of the market prices . What you did just now is entered a future contract . Basically futures are contracts that obligate the buyer to buy an assets and a seller to sell an assets at predetermined future date and future price .
In this case future contract obligate Kumar to sell its 10 bag of rice to you at Rs 100 per bag 1yr from now and obligates you to buy them then at that price . Kumar agrees to this because this means that one bag of rice , 1 year from now whatever the market price is , he will get a profit of Rs 70 per bag of rice .What he did is he limited his risk and locked in his profit . Kumar is playing safe and it works out well for him .
But what about you as a investor , if you are right and the price of rice increase . Then what position you will be in 1 year from now . One year from now the prices of one bag of rice in the open market may even reach to Rs 200 per bag . This means you buy Kumar’s bag of rice at Rs 100 per bag and sell them in the open market at Rs 200 per bag making a profit of Rs 100 per bag or Rs 1000 on the investment of Rs 1000 . I think , this you all understood clearly . But wait a second , what if you are wrong , what if the prices of rice bag do come down . In this situation the market price could drop to even Rs 20 per bag of rice. Now this what you have to understand because it is not going to be good for you .This means that you will have to pay Rs 100 each bag of rice and be able to sell them at only Rs 20 per bag which means you will make a loss of Rs 80 per bag of rice or Rs 800 in the investment of Rs 1000 . Now this is a huge risk to take . But the point arises here is , Is there a way as investor I can limit risk , the answer is yes there is a way , If as a investor you do not want to take risk losing too much money . You can simply have an agreement with you broker and call for a stop loss . This means that as soon as it becomes clear that your loss will go beyond certain level . The Broker will exit the future contract and stop your losses from getting worse , Now what does this means , this means that if as a investor you instruct your broker to stop your loss at Rs 70 per bag of rice the minute the market price reaches Rs 70 . The broker will exit the contract by selling it to someone else and stop your loss at Rs 70 per bag of rice . So in this way you have also limited the risk .
So now you have understood what derivatives is all about . MBA finance student should know what is derivatives because now a days the banks who are coming for placement ask about this concept and if you don’t know about it then they are not going to select you . In my experience I have seen lot of companies who came in VIT University Chennai campus has continuously ask about derivatives to students and why won’t they because jobs are there and going to be there in the future . So , the next time anyone ask you about derivatives, then just say the example of Kumar .