InvestorQ : Can you explain how derivatives work in the stock markets with a very simple example?
Nishant Chandani made post

Can you explain how derivatives work in the stock markets with a very simple example?

Dilmini Mercia answered.
2 years ago

We can understand the working of derivatives with the help of a very simple live example. We all know that derivatives derive their value from an underlying asset. Let us take the example of a tomato farmer and a ketchup factory. The farmer grows tomatoes in the farm and supplies it to the ketchup factory on a regular basis. However, the ketchup factor and the farmer want more predictability and stability in their price and their costs and revenues. Let us assume that tomatoes are currently being supplied at Rs.20/kg to the ketchup factor. But there are sharp seasonal variations in these prices. The farmer will be happy if he can get a price of Rs.19-22 per kilogram for his tomatoes while the ketchup factor is open to a price of Rs.20-23 per kilogram in the ideal case scenario.

Now the farmer and the ketchup factory can enter into an agreement wherein the farmer supplies tomatoes to the ketchup factor at Rs.21/kg. This suits the interests of the farmer and the ketchup factory. At the end of 3 months, the farmer agrees to supply 2 tonnes of tomatoes at Rs.21/kg to the ketchup factory and the ketchup factory, in turn, commits to buy the said quantity at Rs.21/kg. What we have seen here is a basic derivative contract come into existence. This called a forward contract. The underlying in this case is the tomatoes and the farmer and the ketchup factory are bound by the agreement. When this forward contract is listed on a stock exchange and it also becomes standardized, it becomes a futures transaction.