Need and types of financial derivatives

There are several risks inherent in financial transactions and asset liability positions. Derivatives are risk shifting devices: they shift risk from those who have it but may not want it to those who have the appetite and are willing to take it.

The three broad types of prices risks are:

1. Market risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole market. Market risk is also referred to as systematic since it cannot be diversified away because the stock market as a whole may go up or down from time to time.
2. Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price of fixed income securities could fall if the interest rate shot up.
3. Exchange rate risk: In the case of imports, exports, foreign loans or investments, foreign currency is involved which gives rise to exchange arte risk. To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have emerged.

Types of Financial Derivatives:

In recent years, derivatives have become increasingly important in the field of finance. Forwards, futures, options swaps, warrants, and convertibles are the major types of financial derivatives. A complex variety of composite derivatives, such as swap options, have emerged by combining some of the major types of financial derivatives:

1. Forwards: A forward contract is a contract between two parties obligating each to exchange a particular good or instruments at a set price on a future date. It is an over the counter agreement and has standardized market features.
2. Futures: Futures are standardized contracts between the buyers and sellers, which fix the terms of the exchange that will take place between them at some fixed future date. A futures contract is a legally binding agreement. Futures are special types of forward contracts which are exchange traded, that is traded on an organized exchange. The major types of futures are stock index futures, interest rate futures, and currency futures.
3. Options: Options are contracts between the option writers ad buyers which obligate the former and entitles (without obligation) the latter to sell/buy stated assets as per the provisions of contracts. The major types of options are stock options, bond options, currency options, stock index options, futures options, and options on swaps. Options are of two types: calls and Puts. A call option gives a buyer/holder a right but not an obligation to buy the underlying on or before specified time at a specified price (usually called strike/exercise price) and quantity. A put option gives a holder of that option a right but not an obligation to sell the underlying on or before specified time at a specified price and quantity.
4. Warrants: Warrants are long term options with three to seven years of expiration. In contrast, stock options have a maximum life of nine months. Warrants are issued by companies as a means of raising finance with no initial servicing costs, such as divided or interest. They are like a call option on the stock of the issuing firm. A warrant is a security with a market price of its own that can be converted into a specific share which leads at a predetermined price and date. If warrants are exercised, the issuing firm has to create a new share which leads to a dilution of ownership. Warrants are sweeteners attached to bonds to make these bonds more attractive to the investor. Most of the warrants are detachable and can be traded in their own right or separately. Warrants are also available on stock indices and currencies.
5. Swaps: Swaps are generally customized arrangements between counterparties to exchange one set of financial obligations for another as per the terms of agreement. The major types of swaps are currency swaps, and interest rate swaps, bond swaps, coupon swaps, debt equity swaps.
6. Swaptions: Swaptions are options on swaps. It is an option that entitles the holder the right to enter into having calls and puts, swaptions have receiver swaption (an option to receive fixed and pay floating) and a payer swaption (an option to pay fixed and receive floating).

Distinctive Features of Derivatives Market:

1. The derivatives market is like any other market.
2. It is a highly leveraged market in the sense that loss/profit can be magnified compared to the initial margin. The investor pays only a fraction of the investment amount to take an exposure. The investor can take large positions even when he does not hold the underlying security.
3. Market view is as important in the derivatives market as in the cash market. The profit/loss positions are dependent on the market view. Derivatives are double edged swords.
4. Derivatives contracts have a definite lifespan or a fixed expiration date.
5. The derivatives market is the only market where an investor can go long and short on the same asset at the same time.
6. Derivatives carry risks that stocks do not. A stock loses its value in extreme circumstances, whole an option loses its entire value if it is not exercised.

Exchange Traded versus OTC Derivatives Markets:

There has been a sharp growth of around 40 percent a year in the OTC derivatives markets globally. In the OTC markets transactions take place via telephone, fax, and other elections means of communication as opposed to the trading floor of an exchange. Information technology (IT) has enabled this fast growth in OTC derivatives markets. OTC derivatives contracts are more flexible than exchange traded contracts. However, OTC derivatives markets are characterized by the absence of formal rules for risk (a prerequisite for market stability and integrity), the absence of formal centralized limits or individual positions, leverage or margining and the absence of a regulatory authority.

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