What Are Derivatives In Finance | How An Option Works

The concept of a derivative may appear daunting because there are numerous derivative financial instruments in the market that seem complex and difficult to understand. However, fundamentally all derivatives simply derive their value from another underlying item such as a share price or an interest rate.

Derivative financial instruments create rights and obligations that have the effect of transferring between the parties to the instrument one or more of the financial risks inherent in an underlying primary financial instrument.

On inception, derivative financial instruments give one party a contractual right to exchange financial assets or financial liabilities with another party under conditions that are potentially favorable, while the other party has a contractual obligation to exchange under potentially unfavorable conditions.

How An Option Contract Works

In simple terms, parties to derivative financial instruments are taking bets on what will happen to the underlying financial instrument in the future. For example, Party A was taking a bet that the share price in Company Z would rise above $3 within 6 months, and Party B was taking a bet that it would not. Party B would most likely hedge its bet by doing something to protect itself should the market price rise above $3.

It could do this by entering into another derivative with another party, enabling Party B to purchase shares from that other party at $3. Often a chain of derivative financial instruments will be created in this way. Party A will probably not know anything about the chain created.

IAS 32 does not prescribe recognition and measurement rules for derivatives; these are addressed in IAS 39. Instead, IAS 32 includes derivatives in the definition of financial instruments. Other types of derivatives include interest rate swaps, forward exchange contracts and futures contracts.

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