nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒02‒03
one paper chosen by
Stan Miles
Thompson Rivers University

  1. Financial Derivative Markets: Hedging, Speculation, Arbitrage, and Risks Associated with Derivatives By Govori, Fadil

  1. By: Govori, Fadil
    Abstract: Among the most innovative financial markets in recent years are the markets for financial derivatives. Financial derivative markets include markets for forward contracts, future contract, option contracts, interest rate and currency swaps, and credit derivatives. In the financial derivative markets, the risk of future changes in market prices or yields attached to various assets is transferred to someone else, an individual or institution, willing to bear that risk. A forward contract is an agreement between parties to buy or sell an asset on a certain future date for a certain price. In forward contract, one party takes a long position and agrees to buy the underlying asset on a specific date for a specific price. The counterparty takes a short position and agrees to sell on the same date for the same price certain asset. The price specified in a forward contract is the delivery price. Credit risk is implicit in every forward contract because there is always the possibility that the counterparty might not honor the obligation. A futures contract represents the right to trade a standard quantity and quality of an asset at a specified date and price. Future contracts differ from forward contracts in that the size, delivery procedures, expiration date, and other terms of the futures are the same for all contracts. This standardization allows futures contracts to trade on organized exchanges, which provides liquidity to market participants. Futures contracts have a number of useful applications. They can be used to hedge risk in the spot or cash market; to speculate on the future price of an asset; to arbitrage the difference between the two prices. The value of a futures contract is determined by the value of underlying asset and the principle of arbitrage. An option contract gives the holder of the option the right, but not the obligation, to buy an asset, in the case of a call option, or sell an asset in the case of a put option, at a specified price during a specific time period. The price at which the asset is bought or sold is the exercise or strike price. Because the option contract does not obligate the holder to transact, it provides unique payoff possibilities. There are two types of options: European and American. European options can be exercised only at expiration. American options can be exercised at any time. Most options traded in the United States are American options. Swaps represent privately negotiated or OTC securities. In a swap, two or more parties (institutions; the counterparties) contract to exchange cash flows in the future according to some prearranged formula. Mainly, market participants create swaps to hedge volatility in the financial markets. A simple way to understand a swap is to view a swap as a series of forward contracts. A credit derivative is a privately negotiated contract with payoffs linked to a credit-related event, such as a default or credit rating downgrade. Credit derivatives offer a flexible way to protect against credit risk and provide opportunities to enhance yield by purchasing credit synthetically. Derivative financial instruments can be used for three different purposes: hedging, speculation, and arbitrage. Hedgers concern themselves with reducing or eliminating risk. Speculators show interest in profiting from movements in the price of the derivative financial instruments. Arbitragers attempt to profit from price discrepancies in the cash and futures markets. Trading of financial derivatives is not without its own special risks and costs. Although derivatives can be used to help manage risks of other instruments, they also have risks of their own.
    Keywords: Financial Derivative Markets; Hedging; Speculation; Arbitrage; Risks Associated with Derivatives
    JEL: G22 G12 G15 G14 G23 G32 G21 G24 G13 G11
    Date: 2007–01

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