Derivatives: Their Economic and Financial Rationale - Coursework Example

The issue sometimes raised is whether derivatives are necessary, because of the corporate financial disasters and scandals that have hogged news headlines worldwide, or whether they serve some social or economic purpose. If they are necessary and useful, the next question might be: Do derivatives complete the market, and in what way?Futures and options are contracts to eventually buy or sell the underlying securities, and because their values are derived from these securities, they are called derivatives or derivative securities.

In some parts of the world where derivatives are not traded in their exchanges (such as the few national exchanges in Third World countries), investors, whether domestic or foreign, are often reluctant to come in and therefore these stock markets lag behind others. It is widely believed that derivatives serve an essential and vital purpose in any market where financial instruments are bought and sold, in protecting open positions in equities, bonds, and investments in domestic currencies..Derivative, or hybrid, investments, unlike stocks and bonds, do not represent ownership of shares, such as stocks, or a promise of loan repayment, such as bonds, and are once or twice removed from a real product.

For example, a crude oil futures contract is a bet on which way crude oil prices will move, but what happens to the product itself is of no interest to the investor. One may also bet on the S&P500 index, which involves no product, and positions are settled in cash just as in a casino environment. For investors in the stock market, selling a futures index can protect the downside of a long position in a stock portfolio. For the speculator who bets opposite, it can earn profits if the index moves according to expectation inherent in the futures contract he bought or sold.

A futures contract is an agreement that one party will accept delivery of a particular asset – either real or financial – on some date in the future at a price determined today. If intending to buy an asset in the future, one could buy a futures contract today to fix the amount one will pay and avoid the possibility of a price increase. Also, if one wishes to sell an asset in the future, one could sell at a known future price through a futures contract, thus obviating the possibility of a price decreasing between now and the date of the purchase.