DERIVATIVES

Derivatives - as a Versatile Instrument

Derivatives - as a Versatile Instrument

Although derivative like activities have been in process for many hundreds of years, financial derivatives only came to light and grew in the seventies. Chicago was the first to bring out products such as financial futures and options. The first emergence of derivative products was instruments for hedging against the fluctuations in the price of commodities under the conditions of extreme volatility. A derivative is a financial contract or instrument that derives its value from an underlying. This means that derivatives are based on underlying which can be an asset (e.g. stocks and bonds), an index (e.g. S&P 500), or something else (e.g. interest rates). Therefore, derivatives are believed to be reliant on the value of the underlying asset (Canter, et al., 1996).

They are created and traded in two different types of markets: over-the-counter and exchanges markets. Specialized derivative exchanges are operating since many years for exchange traded derivatives. These contracts are standardized and backed by a clearinghouse. Futures contracts are an example of exchange-traded derivatives. Over-the-counter derivatives do not trade in a centralized market; instead, their market is created by dealers. These are the custom instruments where the parties involved determines the terms and conditions of the instrument. Forward contracts are examples of over-the-counter derivatives. Since there is no clearinghouse, the counterparties in the contract are exposed to default risk.

There are four main types of derivatives that can be used:

A forward commitment is a legally binding promise to perform a particular action. A party that makes a forward commitment is obliged to adhere to the terms of an agreement. Forward commitments can be made on exchange-traded derivatives and over-the-counter derivatives (Durbin, 2011). These are customized and private contracts between two parties, where one party has the obligation to buy an asset, and the counterparty has the obligation or compulsion to sell the asset, at a particular price on a particular or a specific date in the future. If the price of the asset increases after inception of the contract, the buyer benefits while the seller loses out. Forward contracts can be written on equities, bonds, assets or interest rates. Some benefits of forwards are:

The amounts can be tailored to suit the needs of the clients

Clear commitments as the contracts are highly illiquid as there is no secondary market for the contracts

Cash flows only on delivery

Contract must be fulfilled therefore the commodity must be bought on the spot market

Default risk exists in the case where the counter-party is unable to pay however the margining systems are being introduced.

Forward contract can be used for hedging for example if a U.K based company has an obligation of $5m in three months time to a US based supplier then the company can enter a 3-month forward contract at the offer rate at the time in order to fix the future price. This provides the company with stability and prevents exchange rate volatility impacting the company. The party that enters the forward contract with ...