Financial instrument is derivative if it meets all the following three requirements:
- It requires no or insignificant investment at the time of entering into contract.
- It is settled at future date.
- Its value is based on price of underlying asset such as foreign currency, shares, sugar, cotton etc.
Derivative is legally enforceable by law.
Forward contract, future contract or currency futures and currency swaps all meet the definition of derivatives.
However, money market money is not a derivative, because:
It requires initial deposit of significant value and
Its value is not based on underlying. Therefore, you know the cost of Hedging in advance.
In addition, currency options are not derivative product, as it requires significant premium payment at the time of purchase.
Derivatives should be used with caution it is easy to enter because of no investment required but it can result in significant gains or losses if used for speculative (gambling) purpose rather than for hedging.
