Classification of Derivatives: Derivatives are classified in terms of their payoffs and as exchange traded and over the counters.
• Linear Derivatives: Linear Derivatives have linear payoff. E.g. Futures and forwards.
• Non Linear Derivatives: Non Linear Derivatives have non linear payoffs. E.g. Options.
• Exchange traded: These are standardized instruments and are backed by clearing house. So there is no default risk. E.g. Futures.
• Over the counters: Over the counters are customized contracts and they bare default risk. E.g. Swaps and Forwards.
Histroy:
The history of derivatives is quite colorful and surprisingly a lot longer than most people think. Derivatives were first instruments developed to secure the supply of commodities and facilitate trade as well as to insure farmers against crop failures. The history of derivatives provides evidence that the first derivatives markets were over the counter (OTC).
Early history of derivative markets in the US:
In 1848: Creation of the Chicago Board of Trade (CBOT) and Creation of the (To-Arrive) contract for grains are formed. In 1865: forward contracts become Standardize. In 1874: Chicago Produce Exchange was created. In 1919: CPE becomes the Chicago Mercantile Exchange. In 1925: First futures clearinghouse was created. In 1922: Futures Act for Grains. In 1936: Options on futures are banned. In 1955: Corn Products Refining Company decision made by the Supreme Court.
Modern brief history of derivatives in the US:
In 1972: International Monetary Market (IMM) for trading currency futures was created. In 1975: first interest rate futures contract create by CBOT. In 1975: Treasury bill futures contract (& options) by CBOT. In 1977: T-Bo...
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...certain cash crunch. if credit rating falls then an institution might lose liquidity and experiences sudden unexpected cash outflows or may some other event that causes counter-parties to avoid trading.
Market Risk: Fluctuation in the prices of that underlying asset cause market risk. This Market risk comprises of four risk factors which include Interest rate risk, Commodity risk, Equity risk and Currency risk. In general risk varies from sector to sector.
Banks use derivatives to hedge against risks that may affect their earnings and other operations which include market risk, counter-party risk interest rate risk and foreign exchange risk.
Farmers use derivatives to lock the price of their crops in order to save their harvest so that they are exposed to price risk.
The importance of derivatives is increasing day by days because of high volatility in the market.
Except in the case of an exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection—
The presence of systemic risk in the current United States financial system is undeniable. Systemic risks exist when the failure of one firm may topple others and destabilize the entire financial system. The firm is then "too big to fail," or perhaps more precisely, "too interconnected to fail.” The Federal Stability Oversight Council is charged with identifying systemic risks and gaps in regulation, making recommendations to regulators to address threats to financial stability, and promoting market discipline by eliminating the expectation that the US federal government will come to the assistance of firms in financial distress. Systemic risks can come through multiple forms, including counterparty risk on other financial ...
“What makes the stock market risky?” is what you are probably asking. Well, my answer would be that the stock market is consistently going up and ...
Flawed financial innovations: the implementation of innovations in investment instruments such as derivatives, securitization and auction-rate securities before markets. The indispensable fault in them is that it was difficult to determine their prices. “Originate to distribute securities” was substituted by securitization which facilitated the increase in ...
The government does this by providing financial assistance to farmers and by managing the cost and supply of certain commodities. There are a few reasons for this. One reason is to provide assistance to family-sized farm owners who have trouble competing with commercial farms. This is supposed to maintain an efficient market balance. Another reason is to control the prices of commodities and keep the global food prices low.
Farmers are essentially the back-bone of the entire food system. Large-scale family farms account for 10% of all farms, but 75% of overall food production, (CSS statistics). Without farmers, there would be no food for us to consume. Big business picked up on this right away and began to control the farmers profits and products. When farmers buy their land, they take out a loan in order to pay for their land and farm house and for the livestock, crops, and machinery that are involved in the farming process. Today, the loans are paid off through contracts with big business corporations. Since big business has such a hold over the farmers, they take advantage of this and capitalize on their crops, commodities, and profits. Farmers are life-long slaves to these b...
... middle of paper ... ... The forced liquidation of some $3 trillion in private label structured assets has been deprived from the financial markets and the U.S. economy has obtained a vast amount of liquidity that the banking system simply cannot restore. It is not as easy to just assign blame within these cases, however it is noted that the credit rating agencies unethical decisions practices helped add onto the financial crisis of 2008 and took into account the company’s well-being before any other stakeholders.
If financial markets are instable, it will lead to sharp contraction of economic activity. For example, in this most recent financial crisis, a deterioration in financial institutions’ balance sheets, along with asset price decline and interest rate hikes increased market uncertainty thus, worsening what is called ‘adverse selection and moral hazard’. This is a serious dilemma created before business transactions occur which information is misleading and promotes doing business with the ‘most undesirable’ clients by a financial institution. In turn, these ‘most undesirable’ clients later engage in undesirable behavior. All of this leads to a decline in economic activity, more adverse selection and moral hazards, a banking crisis and further declining in economic activity. Ultimately, the banking crisis came and unanticipated price level increases and even further declines in economic activity.
The expanding global market has created both staggering wealth for some and the promise of it for others. Business is more competitive than ever before, and every business, financial or product-based, regardless of size or international presence is obligated to operate as efficiently as possible. A major factor in that efficient operation is to take advantage of every opportunity to maximize profits. Many multinational organizations have used derivatives for years in financial risk management activities. These same actions that can protect multinational organizations against interest rate futures and currency fluctuations can be used to create profits for those same organizations.
In conclusion, hedging risk with financial derivatives can give firm range of benefits such as lower probability of having financial distress, lower value of debt ratio, and earn tax benefit. It can be concluded that firm should hedge risk using financial derivatives because lot evidence shows that firm using this strategy is more successful than those who are not. However, since different type of companies facing different risks, they should not necessarily use the same hedging strategy.
Howells, Peter., Bain, Keith 2000, Financial Markets and Institutions, 3rd edn, Henry King Ltd., Great Britain.
Many years ago humans discovered that with the use of mathematical calculations many things can be calculated in the world and even the universe. Mathematics consists of many different operations. The most important that is used by mathematicians, scientists and engineers is the derivative. Derivatives can help make calculations of anything with respect to another event or thing. Derivatives are mostly common when used with respect to time. This is a very important tool in this revolutionary world. With derivatives we can calculate the rate of change of anything with respect to time. This way we can have a sort of knowledge of upcoming events, and the different behaviors events can present. For example the population growth can be estimated applying derivatives. Not only population growth, but for example when dealing with plagues there can be certain control. An other example can be with diseases, taking all this events together a conclusion can be made.
Differential calculus is a subfield of Calculus that focuses on derivates, which are used to describe rates of change that are not constants. The term ‘differential’ comes from the process known as differentiation, which is the process of finding the derivative of a curve. Differential calculus is a major topic covered in calculus. According to Interactive Mathematics, “We use the derivative to determine the maximum and minimum values of particular functions (e.g. cost, strength, amount of material used in a building, profit, loss, etc.).” Not only are derivatives used to determine how to maximize or minimize functions, but they are also used in determining how two related variables are changing over time in relation to each other. Eight different differential rules were established in order to assist with finding the derivative of a function. Those rules include chain rule, the differentiation of the sum and difference of equations, the constant rule, the product rule, the quotient rule, and more. In addition to these differential rules, optimization is an application of differential calculus used today to effectively help with efficiency. Also, partial differentiation and implicit differentiation are subgroups of differential calculus that allow derivatives to be taken to more challenging and difficult formulas. The mean value theorem is applied in differential calculus. This rule basically states that there is at least one tangent line that produces the same slope as the slope made by the endpoints found on a closed interval. Differential calculus began to develop due to Sir Isaac Newton’s biggest problem: navigation at sea. Shipwrecks were frequent all due to the captain being unaware of how the Earth, planets, and stars mov...
As previously mentioned, bonds are one of the more popular types of financial investment in
Financial crises have influenced the os of financial markets in past. The most important the Great Depression in 1929-30, the 1970s inflation failures and the banking difficulties in the 1990s led to problems in the financial markets causing serious disturbance. The recent financial crisis which became known in 2007, though the roots were implanted much earlier, has been the worst situation financial markets have ever faced.