Paper Example on Financial Derivatives

Introduction

The deregulation of the market, the growth in the global trade and the continuing technological developments have over the period of time revolutionized the financial sector. The results of these changes and developments have seen an increased volatility of the market consequently leading to an increase in the need for products of risk management. Particularly, financial risks have risen both in magnitude as well as in frequency. According to Akenbor (2011), financial risks refer to the exposure to a situation of loss, which directly results from the differences that exist between the expected and the actual outcomes values.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

In the current millennium, the financial markets around the world have become significantly volatile than was the case before. Even in some of the most advanced economies, companies and institutions still face wild fluctuations in the rates of interests and the rate of exchanges. In this understanding, financial risks have grown both in quantity as well as their worth. From the perspective of the firms and companies, financial risks pose a rather major threat to the profitability of the company and thus the need to hedge out these risks (Hon, 2013). In light of these challenges, and with the need for companies and organizations to make profits, derivatives have garnered substantial attention from organizations and companies as some of the best approaches of managing risks and hedging out the risks. It is the uncertainty of the financial outcome (Bartram, Brown & Conrad, 2011). Financial derivatives are tools and instruments that are particularly employed by banks as well as other financial service companies in the management of risks that arise from changes in the market prices of the financial products and services (Akenbor, 2011).

A derivative is a financial instrument whose actual value is derived from the value of another instrument. The latter is often referred to as the underlying. When the value of the underlying instrument changes, the value of the derivative changes as well. It is important to note that derivatives are not physical products but contracts that derive their values from changes in the market prices of the underlying. According to the definition provided by the international monetary fund, financial derivatives are financial instruments linked to other financial instruments, indicators or commodities and through which particular financial risks can be traded within the financial markets (Chang&McAleer, 2014). They can be applied in numerous instances such as in the management of the financial risks, hedging, market-to-market arbitration and speculation (Chang&McAleer, 2014).

There are three main users of derivatives including non-financial firms, financial firms, and individual investors. Financial institutions engage in the sale of derivatives as a way of hedging out risks. Non-financial firms, particularly those engaging in international currencies, also take part in derivative transactions as a way of protecting themselves against risks of a decline in currency exchange (Stulz, 2014). Other uses of financial derivatives by non-financial companies include the reduction in the volatility of accounting earnings, increase their earnings, to reduce the current value of their tax liabilities as well as to increase the value of a firm (Adkins, Carter &Simpson, 2007).

Advantages of Derivatives in Trading

Derivatives offer a range of benefits. However, the main benefits of derivatives include the discovery of prices and the management of risks. According to the discussion provided by Gogoncea & Paun (2013), the evaluation of derivatives is primarily based on the establishment of a cloned portfolio. In this understanding, derivatives can be argued to be redundant assets. The main and perhaps the most important advantage of derivatives is that they allow individuals as well as companies to earn income that they otherwise would be unable to acquire or would be acquired but at a significantly high cost (Gogoncea&Paun, 2013). Due to the fact that they are highly versatile, the synthetic status of these derivatives can effectively be established as a way of meeting all the investment requirements that can effectively be applied to any one particular type of market (Gogoncea&Paun, 2013).

The other major benefit of using financial derivatives is that they facilitate the efficient marketing of the underlying assets. In most instances, the markets for the derivatives provide information that facilitates the decision making processes regarding the underlying products. Gogoncea & Paun (2013) explains that swaps are significantly helpful in the production of reliable information about the long-term interest rates since the market for swaps is more liquid and highly attractive as compared to the market for bonds. In this understanding, it can be argued that derivatives enable investors to trade based on information that would have been significantly expensive to obtain.

Credit derivatives have over the past number of years garnered particularly high interest from investors and financial institutions. These derivatives allow the investors to effectively reduce the risks due to credit without the requirement for the removal of the physical assets depicted within their balance sheets (Gogoncea&Paun, 2013). Sales without applying the use of credit derivatives require the consent from the clients. In comparison, credit derivatives effectively represent confidential transactions which do not require the consent of the clients. This enables for an effective distinction between decisions of the relational management and the decisions of the risk management teams within an organization. In addition to this, the accounts and tax status and position of an organization or entity often create a deterrent to the sales thus leading the entity into an otherwise liquid position (Gogoncea & Paun, 2013).

The continued growth in popularity, as well as the market for credit derivatives, clearly defines their effectiveness in the market. The popularity shows that credit derivatives have certain characteristics that appeal to the investors which lacks in other financial instruments. They have been observed to be superior to many risk management tools and effectively allow the transfer of risks to the parties that can effectively bear (Gogoncea&Paun, 2013). Apart from these, credit derivatives also allow a significant advantage of enabling for the estimation of the prices of the underlying assets. Through the establishment or the expansion of the market for the credit risks, observers garner sufficient information and data to better measure the potential costs of risks from credit.

Finally, it is imperative to note that financial derivatives are highly effective in the trade as they require significantly reduced payments in comparison to other forms of assets. As such, the counterparties can effectively take advantage of the differences between the valuation of stocks and bonds, thus enhancing the efficiency of both markets (Gogoncea&Paun, 2013).

Advantages of Derivatives in Public Exchange

Derivative Products

As explained in the discussion above, the primary aim of derivatives is to assist organizations and entities to hedge financial risks. However, it is important to note that derivatives exist in different forms. The main examples of derivatives include futures, option swaps, Swaptions, and options. The discussion that follows briefly explains each of these types of derivatives in an aim to distinguish it from the other types of derivatives.

Futures

These are contracts organized through exchange and which assess and determine the size, time of delivery as well as the prices of the particular commodities in consideration. A future is an agreement between two or more parties to purchase or sell a pre-specified quantity of a particular asset at a specified cost and delivery at a particular date in the future (Chui, 2010). These types of derivatives are in some instances confused with forwards. Though these two types of derivatives are almost similar to each other, there exists a significant different particularly regarding the manner in which they are transacted. First, individuals or participants who trade in futures have the ability to realize gains or losses on a daily basis. In comparison, participants who trade in forward require cash settlements at the time of delivery of the particular assets (Chui, 2010).

The second difference is that future derivatives are often standardized. On the other hand, forward contracts are in most instances customized in order to meet the specific needs of the parties engaged in the trade. Thirdly, futures contracts are often settled through the use of established clearing houses while forwards are settled between the involved parties. Since futures are exchange-traded, they are tightly regulated while forwards are loosely regulated since most of them are over-the-counter contracts (Chui, 2010).

According to the discussion provided by Oldani(2005), futures increase the efficiency of the market through the lowering of the costs of trading and the asymmetry of the information and enhances liquidity through the provision of daily margin settings to all the expiration dates (Bonfim& Moshe, 2014). Since the transparency of these derivatives is usually dependent upon the national and the international laws, it is significantly high. They are particularly used in hedging out and speculating in the markets for financial commodities (Oldani, 2005). It is important to note that the notional value of the future derivatives does not represent the two counterparts' exposure, so long as they settle their positions and status on a daily basis through the use of margins.

Options Swaps

Swaps refer to agreements between not more than two parties for the exchange of cash flows on a specified date or on many dates set up. According to Chui (2010) swaps refers to agreements between two parties to exchange a pre-specified series of cash payments for a specified period of time. Depending on the terms of a contract, the periodic payments can be paid based on fixed interest rates or floating interest rates. In these type of transactions, one party often agrees to make payment of a fixed rate while the other party agrees to a floating rate. In swaps, the amount to be paid is based upon an agreed-upon amount which is referred to as the notional principal (Chui, 2010).

According to Oldani (2005), swaps are over-the-counter contracts that have a longer duration as compared to futures and options and are aimed at satisfying the needs of single clients of the bank. They are such as to establish new opportunities for investments as a way of hedging out any type of financial risk or speculate future occurrences such as credit defaults, hearth-quakes, currency exchange rates changes or changes in the interest rates (Oldani, 2005). The notational value paid out is not a representation of the risks taken but periodical payments to be done by the parties involved.

Options

These types of derivatives allow the holders the right, but not the obligation, to sell or purchase the underlying assets at a pre-specified price in the near future. These types of contracts may either be standardized or customized and are divided into two main types of contracts; a call or a put. Call contracts gives the party purchasing the right to purchase a specified amount of the commodity under consideration at a particular price, often called the exercise price, on, or before a defined data in the future, known as the expiration date (Chui, 2010). On the other hand, put contracts allow the buyer the ri...