Financial Derivative Securities - Coursework Example

Financial Derivative Securities Synopsis The financial derivatives are basically nothing but instruments, financial in natures that are derived from underlying assets which could possibly mean an asset, event or a condition. The investors form contracts using these derivatives as instruments to make profits. This is so by a small value change in the worth of an underlying asset causing a huge fluctuation in the derivative of the asset. So, if the prices go as per the investors’ expectations then there will be profits. Financial Derivative Securities Derivatives are those financial instruments that derive their value from the other assets. Financial derivatives are thus a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or any other form of security. Financial derivatives can be classified into; options, Forward Contract, future contracts and swaps. An option is the right to buy or sell something in future at a predetermined price referred to the strike or exercise price. The counter party can only exercise if the position is favourable. A forward contract is a deal involving two parties to buy or sell an asset at a specified point of time in the future the price which is paid/ received by the parties are decided at the time of entering into contract (Tian, 2005, p. 86). It is the simplest form of derivative contract mostly entered by individuals in day to day’s life. A future is a standardized forward contact to buy or sell the underlying asset at a specified price at a specified future date through a specified exchange. A Swaps Contract is a contract whereby parties agree to exchange obligations that each of them have under their respective underlying contracts or we can say, a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. The parties that agree to the swap are known as counter parties. Derivatives tend to dwindle the level of instability of the underlying assets since they contribute to the enhancement of transmission of information (Maniar 2007, p.4). Many traders find financial derivatives being a better option compared to the underlying securities this is because they can use a situation in a financial derivative as a replacement for the underlying instruments since they offer increased cash flow and reduce the operational costs. Moreover financial derivatives offer a potent instrument for restricting risks that the individuals and other players may face in the business transactions thus managing risks and increasing chances of rewards or profit due to the ability to also take calculated risks. Another vital application of derivatives is the price discovery which means edifying information about future cash market prices through the futures market. These markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking (Ashutosh & Satish 2010, p.17). Introduction of financial derivatives such as options and futures provide the financial administrator with the the skill to generate competent portfolios in order to benefit from the movements of the prices whether upward or downwards. This has greatly influenced the demand for options and futures (Tian 2005, p. 88) .Apart from that , establishment of derivatives could create positions whereby investors in the underlying markets shift their operations to derivative markets, dropping the trading capacity of the underlying asset and thereby escalating the unpredictability of the underlying asset market (Corredor & Santamaria 1994, p.3) Moreover there are various effects of listing and delisting of options and whichever the effects one will have those effects should be reversed by the occurrence of the other. Derivatives make it possible to hedge risks that otherwise would be not be possible to hedge. And when economic actors can manage risk better, risks are borne by those who are in the best position to bear them, and firms can take on riskier but more profitable projects by hedging. On the other hand derivatives can make underlying markets more efficient since these markets produce in formation. For example, in a number of countries, the only reliable information about long-term interest rates is obtained from swaps, because the swap market is more liquid and more active than the bond market. Also, derivatives enable investors to trade on information that otherwise might be prohibitively expensive to use. For example selling stock you don’t own is challenging, since the shares must be borrowed from their owners. This slows the speed at which adverse information is incorporated in stock prices, thereby making markets less efficient. We might identify the basic financial market as the market backed by the underlying financial instruments, which are regarded now as the elements of new financial products and services. Underlying instruments is a comparative concept. Some new instruments today maybe the underlying ones in the future. The extended development of the basic market depend on the establishment and development of derivative market as derivative market shifts risks and is also a kind of profit distributing structure. Derivatives that are based on underlying instruments can provide the instruments with factors needed by supposition and hedge. On the other hand, the prices of derivatives depend on the current price of underlying instruments and the expectations of participators on them, so the scientific pricing mechanism of derivatives is good for the stabilization and rationalization of underlying assets (Mohammud 1997, p. 44). Given the derivatives market’s large-scale nature, users can trade around the clock and make use of derivatives that offer exposure to almost any underlying across all markets and asset classes (Brosen 1991, p. 154). The derivatives market is mainly a specialized extensive market with banks, investment firms, insurance companies and company as its main participants. With put options, a derivative that mimics price risks tends to be managed through hedging. Firms having a centre company contact to underlying factors such as commodity prices, exchange rates, can reduce their net exposures to these factors by assuming offsetting exposures through derivatives. Logically, increasing value enhancers for such company hedging activities are provided. The presence of options which are listed upon request from market participants rather than options exchange officials provides a unique opportunity to investigate the effect of option introductions on the underlying market quality without a particular type of selection bias. Selection bias is a crucial issue in this line of research since stocks for option listings are not randomly selected. Stocks for most option listings are selected by options exchange officials whose goal is to maximise their trading business profits. Financial derivatives provide risk protection with minimal direct venture and capital spending, giving the investors an opportunity to trade on future price, invest directly in the underlying assets. Also, allow better innovations with lower operational costs. The benefits of financial derivatives make them essential and indispensable to the economies and international financial system. Derivatives have not only widened the investment universe, they have also significantly lowered the cost of investing. Derivative markets already have a special regulation and that to impose greater restrictions, if this is not necessary, would have a negative impact on the development of the financial markets; thus it would support a prospective decline in the efficiency of the markets. The coming up of derivative markets in markets possessing features of little size and scarce cash, help out to stabilize their spot markets, escalating the investment prospects set and improving the daily actions of the market (Maniar 2007, p.7). Finally, as put in Clifford (2006, p. 3), financial derivatives permit diverse risks to be passed and isolated in a financial structure and those who are in a position and are willing to take risks at minimum costs become risk holders’ which reduces the costs and will also improve the economic efficiency. In absence of financial derivatives there will be a jolt in the financial markets and the financial markets will be severely affected. The main advantage from derivatives is that they to allow individuals and firms to achieve payoffs that they cannot achieve without them. Bibliographies List Ashutosh V& Satish K. 2010,’ A Case Study on Development of Financial Derivatives Market in India’, Journal of Finance and Economies no.37 pp. 16-29. Print Brosen B.W. 1991, ‘Future trading, transaction Costs, and stock market volatility’, the journal of Future Markets, vol. 11 no. 2 pp 153-163, Print Choi H & Subrahmayam A. 1994, ‘Using intraday data to test for effects of index futures on the underlying stock markets’, The Journal of Futures Markets, vol.14, no.3, pp.293-322. Print Clifford S & Ludger H, 2006, controlling risks in derivatives markets’, The Journal of Financial Engineering, vol. 4 no.2. Print Corredor,P & Santamania R 1994,’Does derivatives trading destabilise the underlying assets’, The Journal of Future Markets, vol.11 no 2 pp 153-163. Print Tian L , 2005 , ‘The Necessity of Establishment of Financial Derivative Market in China’, The Journal of American Science, vol.1no.1 pp. 87-90. Mohammed, C & Said, E 1997, ‘impact of Options And Strategic Decisions’, Financial And Strategic Decisions, vol.10 no.3 pp.43-54. Read More