Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity linked derivatives remained the sole form of such products for almost three hundred years. Derivatives came into spotlight in the post -1970 period due to growing instability in the markets. However, since their emergence, these products have become very popular by 1990’s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use.
Early forward contracts in US addressed merchants’ concerns about ensuring that there were buyers and sellers for commodities. However “credit risk” remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first “exchange traded” derivative contracts in the US, these contracts are called “futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today.
Meaning of derivative instruments:
In a broad sense, many commonly used instruments can be called derivatives since they derive value from an underlying assets that is a derivative is a financial contract that derives its value from another financial product / commodity (say spot rate) called underlying (that may be a stock, stock index, a foreign currency, a commodity). Credit derivatives are based on loans, bonds or other forms of credit.
In a strict sense, derivatives are based upon all those major financial instruments which are explicitly traded like equities, debt instruments, forex instruments and commodity based contracts. As the word implies, a derivative instrument is derived from “something” backing it. This something may be a loan, an asset, an interest rate, a currency flow, a stock traded, a commodity transaction, a trade flow, etc. Derivatives enable a company to hedge ‘this something’ without changing the flow associated with the business operation.
Hence, derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.