Essay on Derivatives: Financial Tool to Predict Market Movements

Introduction

Derivatives are financial tool or instruments that derive their value from the underlying assets. Derivatives try to induce the correlation and prediction of the prices within the capital market as well as the stock exchange market. Derivatives, therefore, offers a contract upon which two or more parties are engaged in the determination of their value through the underlying financial assets. Some such assets include stocks, bonds, commodities, interest rates, currencies and market indexes (Cont, 2006). The derivatives thus project future security through advance investment. Therefore some of the derivatives that are usually used include warrant, forward contracts, swaps, futures contracts and options. Regarding the derivative theories and finance assets with corresponding instruments, the paper will focus on the benefits and demerits of derivatives in the International Swaps and derivative associations. Besides, the discussion will major on the different approaches used in derivatives in speculation of the value fluctuation and possible outcomes as a result.

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Benefits of Derivatives in International Trade

In derivative markets, four major participants ensure that there is proper management of the anticipated risk in order to achieve the set benefits. They include hedgers, speculators, arbitrageurs and margin traders. The derivative markets are either of the benefit or even od demerit depending on how they can handle the risks that are presented on the market. Hedgers ensure that they reduce the volatility of the stock market exchange rates by stabilizing prices of underlying financial assets (Ericsson, Reneby, & Wang, 2006). On the other hand, speculators purchase the financial assets due to anticipation that the asset prices would be high hence making more profits after their resale. In the process, the market trends are established, thus reducing future risk to potential investors. Arbitrageurs are parties that learn market trends of the derivatives and therefore, the time when the financial markets are volatile to hence buying the bonds and stocks at relatively low prices for future resale at a profit. Through the activity, they can benefit from the practice, thus marking considerable gains within their trades. Finally, Margin traders ensure that they have collateral deposits from the different financial market in order to distribute the risk for profit-making purposes (Ericsson, Reneby, & Wang, 2006). The trader mainly covers the credit risk that comes as a result of the financial instrument investment.

Derivatives enable the finance market through hedgers to redistribute the risks and other forms of the drawbacks that may lead to losses. The capital flow and the stock exchange rate are crucial elements that predetermine the merit that the investors need to make profits. Therefore, through derivatives, various, hedgers project the analysis of price fluctuation as well as stability hence establishing the right time to make investments in the capital market as well as that of finance. Consequently, through derivatives, capital flow and credit availability is increased to the investors hence expansion of the business. It is through credit default swap that most directives have found a way to retrieve the functionality of the finance market by proper trading for both bonds and stock securities over the nations (Shiller, 2008). That way, investors are able to make significant profits within the markets.

To some extent, derivatives provide or instead allows commerce to expose and manage external influences of the capital markets primarily on with minimal controls. For instance, in the Britain aviation airline revealed the fuel price. The main aim was to standardize the costs and ensure that they were not to be lowered by any fuel cartels or even increased to protect sellers and buyer. The derivative process, therefore, provides advantageous measure towards the protection of the underlying instrument of the financial asset. The investors hence get access to the information that is vital in foretelling the future cost of the business assets and the marginal profits they would be able to get.

Regarding futures contracts are one-party derivatives that allow the speculators in predetermine of the future exchange rates and the price volatility hence easy to make considerable profits. The mono party derivative consequently leads to a reduction of the risks that are bound to be introduced by multiparty or preferably two parties' disagreements and lack of the transparency in their dealing upon the underlying assets (Shiller, 2008). Thus the derivatives have been used to stabilize the financial system giving it a speculative nature of the market that has enabled its investors and businesses to make profits.

Through exchange trade derivatives, a clear definition of the exchange rates is put across, and thus there is transparency in the market prices for derivatives hence helping the potential investors and existing one to make a significant profit. The standardized contracts, therefore, reduce the transaction cost, thus its efficiency and profitability to the businesses. Just like over the counter trade, derivatives are unregulated, and therefore, there are short procedures involved in the business transactions making it easy to trade ("Corporate Finance Institute", 2020).

Derivatives play a significant role in the enhancement of the portfolio management, whereby various approach in speculation and risk management are addressed as well as providing contract basis that favours investor for sustainable business trend development. The functionality of the derivatives hence induces transparency and enhancement in price mechanism that stabilizes the trade of the capital assets as well as the promotion of revenue generation. Concerning credit risk, operation risk and liquidity risk are the functionality that through derivatives have been managed to reduce them hence an improvement of the business portfolio.

Derivatives have been a great provider of the market movements and the apparent changes in its structure and performance. It offers an analysis of the finance market to expose useful information that enables the investors to predict and learn the trends of the future market prices of the financial assets. The financial market is therefore integrated, leading to the revenue-generating plan within the electronic trading and stock exchange trade.

Risks Associated With Derivatives Market

Derivative market bears various risks and critics within the financial instruments. For instance, significant risks associated with derivatives include lack of transparency, especially in over the counter trading. Interlinkage of the contracts also poses another risk within the derivative market hence improper transaction and commerce activity. Then the credit default swap also leads to a vulnerable risk that indeed leads to poor follow up and integration of the financial markets.

Following the Joint HM treasury and financial service, authority shows that lack of transparency leads to the risk of the supervision and monitoring, thus improper progress in the finance market track. The unwillingness then at times lead to the fall of the market due to lack of the transparency that is exposed to the market. Concerning the change in the market prices that at times may be liquidity and with the aim to reduce the risks, the potential and existing investors may decline their interest upon realization of the non-favouring market trends (Ericsson, Reneby, & Wang, 2006). It, therefore, becomes a problem to expose and let out the progress of the market to the public that in return, poses the risk of imperfect monitoring process and supervision.

There is risk associated with futures contract due to failure to meet the obligations and standards of the arrangements. Such risk influence the financial markets to decline upon which its flexibility and unlawful adjustments are done in the commerce. The risk, therefore, led to poor management and prediction of the reoccurring trade with different parties suffering from the interest and volatility of the bond, stock and commodity exchange. Generally, the potential investor lacks clear information and derivatives contracts that are not reliable in the finance market, among other capital trades (Ahmed, Anwer, Emre Kilic, & Gerald, 2006). The counterparty risk, therefore, poses a significant problem to the participants and thus, they are forced to mark price the market prices to reduce the risk.

In reflection to the management fund association, indicate that derivative poses the operation risks as well as the system risk. Primarily, the operation risk is one of the widespread issues that tend to create and obstacle in the financial market and also in the capital market. It is mainly caused by human errors or inaccuracy in the system control. As a result, the derivative market creates an unsuccessful methodology of providing accurate system control and monitoring so that they can provide reliable information and market trends (Shiller, 2008). Besides the derivatives contract always lack some the aspect of the accuracy, which gives the participants of the market hard times in forecasting the future prices and commercial activity of the capital flow. The process of valuation creates a conflict that, in return, makes it tough to decide on the standard rates of the market. At that point, the prices are always unstable and therefore, it keeps fluctuating.

Concerning the system, the risk is one of the terrible danger that faces the derivatives markets. It is a threat that tends to affect the financial system of different participants and therefore linking the two or multiple of them; it becomes a problem that requires a significant intervention. The credit worth of one party in purchase of the asset commodities shows the difference that exists among them. The gaps thus pose the immediate risk over suppression of one player by the other. The risk tends to affect the magnitude and size of the derivatives markets alongside contract discussion.

The credit defaults cause the risk posed by the derivative markets to some extent upon which with some specifications and information. Regarding the same, the financial institutions and lenders may fail to award the borrowers financial assistance, thus causing low commercial activities within the underlying asset transactions ("Corporate Finance Institute", 2020). The distribution risk, therefore, is one of the impacts that comes in after improper consideration of the derivative markets in the provision of the loans and comparative advantages to the different market participants. The asset transaction hence becomes a challenging process that indeed portrays a significant decline in the capital flow.

Recommendation as Per Roles of the Derivatives Market

Based to the two types of the Swaps, that is interest rates swaps and currency swaps, enable all the participant of the derivative markets to make concrete decisions on when to intervene and when to transact in the asset trade. It predetermines the interest rate at which to make payment of particular or specific underlying assets such as bonds and securities. For that reason, it is the mandate of the derivative market to stabilize the interest rates and the development of the price mechanisms for perpetual stabilization of the commodity and stock exchange rates. The derivative markets, therefore, have the role in promoting notional principal in mitigation of the floating rates. The derivatives market perhaps is one of the contracts that should aim at rectifying the existing barriers within different markets and participant parties in the exchange, borrowing terms, and determination of the financial asset rendering. The banks should,...