A Brief Note On Financial Derivatives

2698 WordsApr 28, 201511 Pages
Financial Derivatives Introduction Derivatives are financial instruments whose values are derived from the values of other, more basic, entities, known as the underlying assets. For example, the value of a stock option depends on the price of the relevant stock. Derivatives Markets In the financial markets derivatives are traded on:  Stocks  Stock indices  Exchange rates  Interest rates  Bonds  Credit risk  Commodities (such as electricity, wheat, oil) [4] Derivatives are traded in two different ways – they are traded either on an exchange or over-the-counter (OTC). The advantage of trading derivatives on an exchange is that the contracts are standardized by the exchange and credit risk is eliminated. Open-outcry system was used in the past, but increasingly they are switching to electronic trading. OTC derivative market constitutes of a telephone- and computer-linked network of dealers at financial institutions, corporations, and fund managers. The OTC contracts are not standardised so a small amount of credit risk is present in these. [4] How Derivatives are used  To hedge risks  To speculate (take a view on the future direction of the market)  To lock in an arbitrage profit  To change the nature of a liability  To change the nature of an investment without incurring the costs of selling one portfolio and buying another [4] Types of Traders • Hedgers use derivatives to reduce risk from potential future market movements (however there is no guarantee that the
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