Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A Handbook of Structuring, Pricing & Investor Applications (Financial Times)
The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives.
For example, a call option on the stock of Coca-Cola is a derivative security that obtains value from the shares of Coca-Cola that can be purchased with the call option. Call options, put options, convertible bonds, futures contracts, and convertible preferred stock are examples of derivatives. A derivative can be either a risky or low-risk investment.
The need for a derivatives market
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse
people in greater numbers
5. They increase savings and investment in the long run
Derivatives are used by investors to:
provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;
speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);
hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;
obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level).
Derivative Market and Financial Risk
Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In today’s’ world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns. It is true that growth of derivatives market reveal the increasing market demand for risk managing instruments in the economy.
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