| 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. |