MARKETS AND FINANCIAL INSTRUMENTS
* Financial instruments that detach the price risks and rewards from assets so that these risks and rewards can be allocated to a party without regard to interests in the underlying asset.
* Derivative instruments (or simply derivatives) are a category of financial instruments that includes options, futures, forwards and swaps. While there is general agreement among financial practitioners as to which instruments are considered derivatives and which are not, coming up with a general definition that conforms precisely to that understanding is difficult.
Innovation in the Financial Markets
In policy and, too often, academic discourse, “innovation” carries a positive connotation. But the social implications of an innovation can be complex and often negative. Albert Einstein articulated the mathematics of physical relationships between mass and energy. But one practical application was nuclear weapons, and the consequences for the world have been mixed, to say the least. Similarly, the quantitative experts at the big banks have generated complex analyses of relationships among prices within and across asset classes: debt, equity, currencies and commodities. New financial instruments that are designed to reflect the relationships identified by the “quants” have proliferated. Innovation in the financial markets can be useful, but also harmful. As with Einstein’s work, some of the consequences of financial innovations are dangerous and volatile. Fundamental Characteristics of Derivatives
The most significant financial innovations are tradable contracts that allow market participants to experience the financial consequences of rising or falling prices of asset classes without actually owning the assets. These contracts synthesize the financial consequences of owning an interest in the asset. For example, instead of owning a barrel of oil, an investor can “own” changes in the price of oil, up or...
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