Kimberly M.

Duldulao

BSA 4A

Written Report

Topic: Introduction to Derivative (1st part)

Derivatives are very popular in this modern era. However, it has been noted that it existed
and used by mankind for a very long time. Uncertainty is an idea that’s disliked by humans even
before. Hence, the need to offset this uncertainty gave rise to evolution of contracts, the birth
of derivatives.

The definition of derivative is that it is a financial instrument with a value that is derived
from the changes in value of an underlying item. It has three main characteristics which are:

1. Its value changes in response to the change in an underlying item

2. Requires no initial net investment (or very minimal initial net investment)

3. It is settled at a future date.

The first characteristic can be observed when derivatives are used as a hedging instrument
which will be discussed in the following chapter. But to give you an idea, such derivative
contracts can be used to hedge a position, protecting against the risk of an adverse move in an
asset. (Hedging refers to the practice of reducing or eliminating fully the risk associated with
holding a volatile asset).

The second characteristic refers to the two main broad types of derivatives. The former
refers to forward contract, wherein it requires no initial net investment. According to Milan,
sometimes these contracts are not recorded at the date of transaction. The latter refers to
option contracts, wherein it requires a very minimal cash outlay which is called option
premium.

The third characteristic states that it is settled at a future date. Since a derivative contract
is an executory contract, it is consummated at a future date.

It is important to recognize that in every derivative arrangement there are two positions,
the short position and long position. In a forward contract, a party agrees to buy or sell an asset
at a given price at a future date τ. The party that agrees to buy the asset, is taking a long
position. The party that is selling is taking a short position. In the context of options, long is the
buying of an option contract. A long position is the opposite of a short position.

The brief definition of forward contract is that this type of contract gives holder both the
right and full obligation to conduct a transaction involving an underlying asset.