The world’s largest financial market today is therefore without doubt the derivative market. Derivatives have come into existence because nearly every business has its risks. Derivatives are used to protect against key-business risks which are beyond our control, such as movements in the markets of commodities and foreign exchange . Those who use derivatives as a way of managing risk are called hedgers. Martin Taylor, former Group Chief Executive of Barclays, compare risk with energy; “Risk is neither created, nor destroyed, merely passed around.” This is where the speculators play an important role in the derivatives market. The speculators have no interest in the underlying itself, but for the possibility of a reward they are willing to accept a certain level of risk. Without the speculators the derivatives markets would not function. The third group of players in this market is the arbitragers. These people look for mis-pricing and market mistakes, this give them a risk-free profit, a situation that gets the mistakes to disappear before becoming too large. After a number of huge derivative losses in the mid-nineties, a lot of criticism was pointing at the derivative trading. For example, Orange County lost $1 billion in SWAPS contracts and went bankrupt, Barings Bank shut down business after a £880 million loss caused by futures trading in Singapore.
In this essay, I will look at both the upsides and downsides from the use of derivative instruments, mainly focusing on exchange traded derivatives. Different user groups such as private investors, companies, banks and traders, will be taken into account. In addition, I will discuss whether... [continues]
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