Advantages And Disadvantages Of Derivatives

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Derivatives are financial contracts whose price is either linked to the price of an underlying asset, commodity, rate, index or the occurrence or significance of a certain event. The phrase derivative originated from how the price of these contracts is derived from the price of some underlying commodity, security or index or the magnitude of an event. The set of financial instruments that include futures, forwards, options and swaps are referred to by the term Derivative. A derivative can be combined with a security or loan which will be then called a hybrid instrument or alternatively a structured security and structured financing. (Dodd, R., 2002).

Derivatives trading take place in two markets, the over-the counter-market (OTC) and the organized derivative exchange markets. Contrary to the OTC markets that allow derivatives contracts to be individually customized to the risk
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Therefore, derivatives are traded separately from spot market. Derivatives are not always simple and straightforward. There are some derivatives that their characteristics and features are difficult to understand. These derivatives are called “exotic derivatives”, which include barrier option, which is a type of option that its exercise depends on whether the price reaches a barrier level in the maturity date and it has a lower premium than that of the ordinary option (Hull 2003: 439), caput, which is an option to buy a put, cacall, which is an option to buy a call, and contingent premium option, which is a type of option that its premium payment is postponed till the maturity date and its premium is higher than that of ordinary options, if the option is in-the-money at the expiration date so the premium will be paid, but in the case of out- and at-the-money, the premium will not be paid. Any small change in the price of the underlying asset may cause a huge change in the derivative’s price (Federal Reserve Bank of Boston 2002:
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