Deivatives
A derivative instrument is one whose performance is based (or derived) on the behaviour of the price of an underlying asset. The underlying itself does not need to be bought or sold. A premium may be due. A true derivative instrument requires no movement of principal funds. It is this characteristic that makes them such a useful tool to both hedge and speculate. (Taylor: 2) A derivative product can be used for risk management or speculation, for risk mitigation, or risk taking. The instrument itself can be bought or sold on an exchange or the over the counter market (OTC). Derivatives essentially break down into three key financial techniques futures, options, and swaps. (Steinherr: 13)Futures - the basic unit of exchange in the futures market is the futures contract. Each contract is for a set quantity of some commodity or financial asset, and can only be traded in multiples of that amount. A futures contract is a legally binding agreement providing for the delivery of various commodities or financial entities at a specific date in the future. (Kleinman: 3)· Stock Index Futures are effectively a bet on an upward or downward movement in a particular stock market index.
· Currency futures protect a hedger against alterations in exchange rates that could affect the profitability of a particular project. Export Co will receive 30 million pounds on September 19 2000, from a customer in Britain. · Futures are used in underwriting of fixed income securities but not in equity underwriting. Swaps - there are both interest rate and currency swaps arising as a result of local differences in interest rates and currency markets, and differing credit ratings between various institutions involved. (Bernstein: 44)A currency swap is an agreement between two or more parties to exchange interest obligations, for an agreed period, between two different currencies, and at the end of the period to re-exchange the corresponding principal amounts, at an exchange rate agreed at the beginning of the transaction. (Taylor: 170)Interest rate swaps, one party agrees to pay the other party interest at a fixed rate on a notional principal for a number of years. A hedger uses futures, forwards and options to reduce the risk that they face from potential future movements in a market variable. Characteristics of futures markets: (Stein: 4)· There is only a small number of actively traded commodities with futures markets. Take a long position in four April futures contracts.
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Acceptance Essays
