Show How Transactions in Derivatives Can Be Used to Either Hedge Risk or to Open Speculative Positions.
Economics of the Financial System
Show how transactions in derivatives can be used to either hedge risk or to open speculative positions.
Derivatives have become popular in response to the increasing volatility and complexity of financial markets. A diverse range of new financial products have been created to enable market participants to handle the risks arising from trade in securities and to speculate on future expected movements in securities prices, without direct trade in the assets themselves. Derivative contract creates a promise to deliver or trade an underlying product at some time in the future. The contract gives one party a claim on an underlying asset or cash value of the asset, at a fixed date in the future. The other party is contractually bound to meet the corresponding liabilities. Financial derivatives are traded on organized market such as LIFFE (London International Financial Futures Exchange) and through the intermediation of the clearing house system, there is more flexibility of exchange, and the risk of credit default is reduced. The two parties need not know each other they only have to satisfy the exchange that they are creditworthy to transact.
The initial purpose of derivative contracts was to allow traders to hedge risk which they faced in the cash market. Two of the most popular derivative instruments are financial futures and options. Financial futures commit the parties to buy or sell underlying assets at set prices on an agreed future date. The benefit of financial futures in its most basic form can be exemplified by a poultry farmer who is worried about the risk of price fluctuations in eggs for instance. He knows in 8 months he will sell a certain quantity of eggs. He can hedge against this risk by selling (going short) an eight month “future” in eggs. The “future” will consist of a standard amount of chicken to be exchanged in eight
Show how transactions in derivatives can be used to either hedge risk or to open speculative positions.
Derivatives have become popular in response to the increasing volatility and complexity of financial markets. A diverse range of new financial products have been created to enable market participants to handle the risks arising from trade in securities and to speculate on future expected movements in securities prices, without direct trade in the assets themselves. Derivative contract creates a promise to deliver or trade an underlying product at some time in the future. The contract gives one party a claim on an underlying asset or cash value of the asset, at a fixed date in the future. The other party is contractually bound to meet the corresponding liabilities. Financial derivatives are traded on organized market such as LIFFE (London International Financial Futures Exchange) and through the intermediation of the clearing house system, there is more flexibility of exchange, and the risk of credit default is reduced. The two parties need not know each other they only have to satisfy the exchange that they are creditworthy to transact.
The initial purpose of derivative contracts was to allow traders to hedge risk which they faced in the cash market. Two of the most popular derivative instruments are financial futures and options. Financial futures commit the parties to buy or sell underlying assets at set prices on an agreed future date. The benefit of financial futures in its most basic form can be exemplified by a poultry farmer who is worried about the risk of price fluctuations in eggs for instance. He knows in 8 months he will sell a certain quantity of eggs. He can hedge against this risk by selling (going short) an eight month “future” in eggs. The “future” will consist of a standard amount of chicken to be exchanged in eight
References: 1) http://news.bbc.co.uk/1/hi/2817995.stm Accessed on the 20th April 2010 2) http://www.globalresearch.ca/index.php?context=va&aid=8634 Accessed on the 28th April 2010 3) Howells P & Bain K (2007) Financial Markets and Institutions, London: Prentice Hall 4) Mervyn K. Lewis (1999) The Globalization of Financial Services, Cheltenham: Elgar Reference Collection 5) Rutterford J & Davison M (2007) An Introduction to Stock Exchange Investment, New York: Palgrave Macmillan 6) Howells P & Bain K (2002) The Economics of Money, Banking and Finance, Essex: Pearson Education 7) Henderson R (1993) European Finance, Berkshire: McGraw Hill Book Company 8) Gitman L & Madura J (2001) Introduction to Finance, Boston: Addison Wesley 9) Heffernan Shelagh (1996) Modern Banking in Theory and Practice, Chichester: Wiley 10) A.D Bain( 1992) The Economics of the Financial System, Oxford: Blackwell