Assessing the Different Types of Derivatives - Essay Example

The major classes of derivatives are Futures/Forwards which are contracts to buy or sell an asset at a specified future date, Optionals which are contracts that give a holder the right to buy or sell an asset at a specified future date and Swappings where the two parties agree to exchange cash flows. Derivatives are often subject to criticisms such as large losses, counter-party risk, and unsuitably high amount of risk for small or inexperienced investors, large notional value and leverage of debt in the economy.

In spite of these it has huge advantages such as facilitating the buying and selling of risk thus having a positive impact on the economic system. As former Federal Reserve Board chairman Alan Greenspan commented in 2003 the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century. In this paper the pros and cons and the circumstances under which derivatives such as forward contracts, future contracts, spot contracts, call options, hedging, interest rates swaps, currency swaps and credit swaps are used, are discussed.

(Note: Wikipedia, the free encyclopedia, Derivative(finance)) Forward Contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time.As suggested by the International Journal of Sheep and Wool Science, volume 55(2007), results suggest that income stabilization and price risk management were the two major pros of the forward contract method although these were strongly overshadowed by the list of cons: pricing, complexity, dominance of the auction system and production risks.

Allaz and Vila (1993) suggest that there is a strategic reason (in an imperfect competitive environment) for the existence of forward trading, that is, forward trading can be used even in a world without uncertainty In finance, a futures contract is a