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Introduction
Derivatives are defined as substances that are created from others as defined in chemistry. Similarly, financial derivatives are instruments that allow value exchanges based on pre-existing acts. Usually, the owner of the real stock enters into an agreement with someone who will be willing to buy that stock at an established price at some time in the future. The latter is the most common form of arrangement.
The role of financial derivatives
Financial derivatives have two major roles. These are:
* Speculation
* Hedging
Financial derivatives are instrumental in the hedging process because through them, parties can exchange risk. Usually, this is possible through the use of an underlying asset or a stock that actually exists. However through financial derivatives, it is possible for the electricity manufacturer to be sure about the process which he will receive for his services from the electricity distributor thus minimising his risk. Conversely, the electricity distributor is now sure of the availability of electricity through the financial derivative. In other words, both parties have minimised their risk. (Veale, 2000)
Derivatives are also instrumental in the process of hedging because of the fact that they are quite simple in themselves and do not require intricate balance sheet formulations. Derivative products can be set up regardless of the fact that those products do not actually exist. Through this channel of investment, traders have the opportunity of hedging themselves against the risk of actually purchasing the future stock using their actual value. (Francis et al, 2003)
The second attribute about financial attribute is with regard to their role in speculation. Research shows that large numbers of traders engage in speculative trading this financial derivatives. Numerous institutions believe that it can be possible to establish a trend of how a particular form of security will behave in the future. Investors usually call this kind of investment, directional playing. Besides that approach, speculation can also be done on the nature of a security's volatility.
Some people argue that derivatives are usually created or set by establishing a portfolio that will allow replication. Consequently, this same group believes that if this portfolio can be replicated in another way, then there is really no need for them. However, such people are gravely mistaken. This means that those stock owners or businesses would have to spend too much capital on such a venture. (Jackson, Brewer and Moses, 2000)
The second purpose that derivatives provide to the stock owner or to the purchaser is that the they are a formula or strategy that allows them to suggest possible investments in the future. In other words, if the business was to try and do this on their own without an investor, they would most likely get it wrong. The third aspect is that investors in financial derivative need not worry about changes in prices of their current stock.
Derivatives go a long way in minimising the rate of volatility in any given market. A large percentage of the firms used were fond of using financial derivatives to minimise their foreign exchange risks. It was found that this particular function was reduced by eleven percent through this method. (Briys et al, 1998)
The latter reasons are some of the most common motivations for choosing financial derivatives. However, other firms may choose to utilise financial derivatives for other benefits too. For instance, financial derivatives allow respective companies to minimize their tax liability.While this nature can be deemed as an advantage, in certain instances it can become a huge loss. For example, it presents a large notional value thus causing a scenario where the respective investor cannot be able to compensate for looses. One of the leading investors in the world Buffet Warren asserted that financial derivatives are so dangerous tat they can even cause economic crises. He explained this assertion by stating the fact that many people turn to the financial derivatives market to guide them on future investments instead of looking at the actual market. This may eventually cause market distortions and may be propagated to other parties engaging in investments, eventually, a country's economic situation may be severely impeded. The end result of this is that lack of market knowledge and little experience may cause poor financial decisions.
How financial risk managers can use futures and options to hedge financial risks
Futures may be defined as forms of financial derivatives which require one party to purchase a given security at a specified date is the future. Options on the other hand refer to financial derivatives that give holders the choice of purchasing a fixed amount of security or stock at a certain price during a specified date in the future. Additionally, options may allow investors to sell a known amount of stock at a specified price at a specific time in the future. Usually, options require a pre-existing amount of stock usually called the option premium. The following summarises the problems
Expected stock to be received after one year-$20 million/16 million pounds
Current exchange rate-0.8 pounds
Rate of depreciation in dollar value-10%
Amount of money lost due to depreciation of the dollar-1.6 million pounds
Amount of money received without future's option-14.4 million pounds
Forward rate-$ 0.78
Amount received with future's option-15.6 million pounds
As it can be seen from the figures above, this UK exporter will be able to protect himself from the losses that may arise out of a fall in the exchange rate.In this case, the exporter took up a financial position in the form of a futures contract. The risk under consideration in this scenario is the depreciation of the dollar. The exposure under consideration is the twenty million dollars expected after a period of twelve months. This risk has been hedged well through the assistance of the futures contract. No money will be changing hands between the exporter and the investor at the beginning of the futures contract.
The following is a summary of what Ann stands to loose if she had used a another method for purchasing stock instead of options;
Initial investment -1000 pounds
No. Of shares to be purchased-100
Amount to be borrowed in order to control 100 shares-4000 pounds
As it can be seen above, Ann would have to borrow the rest of the amount if she operated without the stock options and would eventually have to pay an interest on the loan. This also means that she would have to borrow and still utilise her own money to make this investment.
There is also another serious risk with using the direct approach (without stock options), Ann would have to let go off her five thousand pound investment in addition to the entire interest of the value of the stock that she invested if the stock price went all the way to zero. In this regard, all that Ann will stand to loose in case the stock price falls to a value of zero is one thousand pounds.
Conclusion
The essay has examined the role of financial derivatives. Its main purpose is to minimise risk while at the same leverage resources i.e. it allows investors to control securities or stock with minimal resources. Author is associated with ResearchPapers247.Com which is a global Research Papers and Term Papers Writing Company. If you would like help in Research Papers and Term Paper Help you can visit ResearchPapers247.Com>
Reference
Veale, S. (2000): Stocks, Bonds, Options and Futures; Prentice Hall Press
Thomas, Liaw and Moy, R. (2000): The Irwin Guide to Bonds, Stocks, Futures, and Options; McGraw-Hill
Neftci, S. (2000): Introduction to the Mathematics of Financial Derivatives; Academic Press
Jackson, Brewer and Moser (2000): The Value of Using Interest Rate Derivatives to Manage Risk at U.S. Banking Organizations; Economic Perspectives
Briys, E. et al (1998): Derivatives, Options, Exotic and Futures; John Wiley and Sons
Francis, J. et al (2003): The Handbook of Equity Derivatives; Irwin Publishers.
Gardner, D. (2001): Introduction to Swaps; Pitman Publishing.
Robert, A. Jarrow, B.and Stuart, T. (2004): Derivative Securities, Ohio, South-Western Publishers
McLauglin, R. (1999): Over-the-Counter Derivative Products; McGraw-Hill
Millman, G. (2002): How Rebel Currency Traders Overthrew the Central Banks; Free Press
Peck, E. (2001): Selected Writings on Futures Markets; Chicago Board of Trade Publishers
Pilipovic, D. (1998): Valuing and Managing Energy Derivatives; McGraw-Hill
Ritchken, P. (2003): Derivative Markets: Strategy, Theory and Applications, Harper Collins
Scholes, M. (1998): Derivatives in a Dynamic Economic; The American Economic Review 88, 3, 350-70
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