Linkage Between Underlying Assets and Derivatives Market

Topics: Derivative, Derivatives, Futures contract Pages: 4 (1296 words) Published: May 21, 2013
Derivatives are securities whose cash flows depend solely on the prices of other marketed assets (Berk et al., 2009). The main types of derivatives are options, futures, forwards and swaps. Derivative contracts are either traded Over-the-Counter (OTC), meaning off-exchange, or traded on specific derivatives exchanges. Ever since the credit crisis burst in 2008, derivatives have been seen as complicated instruments deprived of any economic sense, mainly used to gamble and speculate on the market. Nevertheless, such financial tools have the advantages of bringing more efficiency on the market and helping investors to control risk and also discover the price of an underlying asset.

Derivatives are mainly used by financial actors for hedging, speculating and also for arbitrage purposes, depending on the financial actors’ attitude towards risk. As far as hedging is concerned, investors use derivatives in order to hedge their positions against fluctuations of market variables and credit risk. Besides, derivatives are also a way for investors to speculate on a particular direction that a given market variable might take. When speculators are confident on such market evolution, they will add liquidity into this market in order to generate significant profits, hence taking considerable risk as well. Since a hedging position is “mirrored”, speculators are required to find investors who have the exact opposite view as theirs in order to seal a deal. Lastly, derivatives are also widely used for arbitrage purpose, which means taking advantage of market inefficiencies by exploiting pricing disparities. Therefore, derivative instruments play a significant role in discovering prices (Commission of the European Communities – henceforth “CEC”, 2009). According to the CEC, the prices determined in the derivatives market are rather accurate as a reference price, considering the specific risk involved in the transaction. This fact is illustrated by the CEC’s research staff...
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