Financial derivatives have crept into the nation's popular economic vocabulary on a wave of recent publicity about serious financial losses suffered by municipal governments, well-known corporations, banks and mutual funds that had invested in these products. Congress has held hearings on derivatives and financial commentators have spoken at length on the topic. Derivatives, however remain a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products. In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad." When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy.
A derivative is a contractual relationship established by two (or more) parties where payment is based on (or "derived" from) some agreed-upon benchmark. Since individuals can "create" a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there is no definitive list of derivative products. Why Have Derivatives?
Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes. For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party. More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. These investment managers may decide that it is more beneficial to assume a specific "risk" characteristic of a security. For instance, several derivative products may be created based on debt securities that represent an interest in a pool of residential home mortgages. One derivative product may provide that the purchaser receives only the interest payments made on the mortgages while another product may specify that the purchaser receives only the principal payments. These derivative products, which react differently to movements in interest rates, may have specific appeal to different investment strategies employed by investment managers. The financial markets increasingly have become subject to greater "swings" in interest rate movements than in past decades. As a result, financial derivatives have appealed to corporate treasurers who wish to take advantage of favorable interest rates in the management of corporate debt without the expense of issuing new debt securities. For example, if a corporation has issued long term debt with an interest rate of 7 percent and current interest rates are 5 percent, the corporate treasurer may choose to exchange (i.e., Swap), interest rate payments on the long term debt for a floating interest rate, without disturbing the underlying principal amount of the debt itself. RISK INVOLE IN DERIVATIVES:
There are four risk associated with derivatives.
* Market risk
* Operational risk
* Counter party credit risk
* Legal risk
The risk to earnings from adverse movements in market...