Derivatives - Literature review Example

?Literature Review: Derivatives Introduction This present paper presents a critical analysis on the financial instruments known as derivatives. The paper will utilise a wide array of secondary sources that will comprise of scholarly books, journals, and credible websites. The literature review on the derivates will cover on various aspects relating to the financial instrument such as types of derivatives, types of derivative contracts, the use of derivatives, and even the contribution of the derivative market to the economic function within a country. Derivatives With reference to the writings by Rubinstein (1999), he stated that the financial market has witnessed various advancements and growth over the past centuries. Traditionally, the financial market was mainly composed of stocks trading only but it has evolved over the past centuries and this has lead to the inclusion of additional financial instruments in the market at both public and private level. The evolution of the market led to the development of various financial instruments that are designed for different purposes and for use by investors with varying objectives. According to Khullar (2009), this evolution has necessitated the inclusion of various players in the market with a common objective of making profit. Equally there has been increased regulation in the financial market that targets the new practices that have been developed, with the latest being the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that covers derivatives reforms (Hull, 2011). As for Raghuram (2006), he stated that with the development of the financial market, there have been increased calls from investors to cushion them against certain risks that could cause them to incur losses. Moreover, the investors have been keen on investment strategies that can guarantee them a substantial return on their investment within a stipulated duration. Hull (2006) stated that such new preference from investors lead to the development of financial instruments such as derivatives, which Chance and Brooks (2010) described as financial instruments that gain their value from the value of other class of assets, meaning that they do not have any intrinsic value of their own. According to the writings by SWAP, (2011), derivative transactions entail a number of financial contracts such as forwards, collars, futures, floors, caps, options, swaps, deposits, and structured debt obligations. With reference to the writings by Durbin (2011), the origin of derivates is traced back to the 18th century whereby the earliest form of derivatives known as rice futures were been traded on the Dojima Rice Exchange. In the studies conducted by Hull (2009), he stated that derivatives are essentially contracts between two parties who have agreed on certain conditions under which financial transactions are to be settled and he further added that the most commonly used underlying assets in derivative transactions include currencies, interest rates, stocks, bonds, and commodities. Derivative contracts are categorized into two groups that comprise of the exchange-traded derivatives, which are derivatives that are transacted in a specialized derivatives exchange. The second group of derivatives is the privately traded derivatives that are traded over-the-counter and therefore, the transactions are not undertaken with the assistance or expertise of an intermediary or the exchange platform (Institute for Financial Markets, 2011). An example of the privately traded derivates is the swaps. Additionally, derivatives are categorized as either option products or lock products; Shirreff (2004) stated that option products give buyers certain rights but they are not under any obligation to agree to the contract under the terms stipulated, an example of an option product is interest rates caps. While lock products underpin the parties in the contract to the terms stipulated until the expiry of the contract, examples of lock products include forwards, futures, swaps. It is of essence to note that the classification of derivates is mainly based on four main factors that include the type of underlying assets entwined with the derivate, the relationship between the derivative and the underlying asset, the market that the derivative transaction will take place, and the returns they offer (Whaley, 2006). In a bid to offer a glimpse of the magnitude of the derivates market, Liu and Lejot (2013) stated that as of June 2011, the derivative transactions that had so far been conducted via the over-the-counter totaled to approximately $700 trillion while the amount of transaction conducted via the exchanges totaled to approximately $83 trillion. However, Liu and Lejot (2013) lamented that these figures are on the upside and they do not represent the true market value as well as the associated credit risk that investors face. Nevertheless, even when the figures are scaled down they would still represent large sums of money that even surpass the total expenditure of the United States government which was at $3.5 trillion in the past year and even the current value of US stock market, which stands at $23 trillion (Liu and Lejot, 2013). These facts indicate the magnitude of the derivatives market and its capabilities. Types of derivatives Boumlouka (2009) wrote that there are mainly two types of derivates in the market and their distinguished from each other by the way they are traded in the market. The first type of derivative as already noted in the previous section is the over-the-counter derivatives, which are typical derivatives that are transacted on a private level between two parties. The parties involved in the over-the-counter derivative transactions include hedge funds and banks, and this market is the largest in the overall derivatives. Because of the fact that transactions are performed on private level it means that there is minimal disclosure of information to the public concerning the market and for this reason it remain less regulated. Chance and Brooks (2008) stated that the other type of derivatives are the exchange-traded derivatives that are typical transacted via derivative exchanges or other forms of exchanges. Under the derivative exchange market, investors trade on contracts that are standardized and already defined by the exchange authority. Because of the fact that derivates in the exchange system pass through a formal process it means that the derivative market is highly documented, which enable the implementation of various regulations. Ferguson (2008) listed some of the largest derivative exchanges in the World and they include Eurex, which covers the European market, the Korea Exchange, and the CME group, which covers the United States’ market. Types of derivative contracts One of the most popular type of derivative contract is the forward contract, which has been described by Ross (1999) as abiding agreement between two parties for the purchase or sale of specified amount of current stocks or bonds at a price that is pre-determined while signing the agreement. The price or rate agreed upon is usually termed as the forward price or rate. The second common type of derivative contracts is futures, which are contracts for purchasing or selling an underlying asset on pre-determined date or before the date. Wilmott et al. (2002) stated that forward contract and future contract differ in the sense that the forward contracts are usually not standardized because the parties in the forward contracts draw-up their own contract. Under the future contract, the contracts are standardized because designated clearinghouses that manage exchange platforms where contracts are purchased and sold draw them. Thirdly, Mattoo (1997) described options as the purchase by an investor of a right without the obligation to buy or sell a specified amount of currency, stock, or bonds to or from the exchange market. By purchasing options, the investor covers his exchange risk forward while at the same time he is bound to gain if the exchange rate moves to his or her favor. Perold (2004) stated that the price at which either the purchase or sale can take place is the strike price, which is stipulated when both parties sign the contract and each option has a expiring date that is known as notification case or exceeds. According to Hull (2011), European options can only be exercised on the expiring date but American options can be exercised any time before the expiring date and therefore, they are much cheaper. There are two types of options and they include the call option and the put option. These two options differ in the sense that the call option is designated for purchases while the put option is designated for selling. Under both options, the buyer and seller can purchase or sell a certain amount of assets at a specified strike price, before or on the date stipulated in the future, but they are not under any obligation to exercise these options. Chance and Brooks (2010) further added that options present investors with choices such as to deal if the rate favors them, sell the option back to the bank if the rates favor him but does not require the option, or abandon the option altogether and ether deal on the spot basis. Lastly, Chance and Brooks (2010) stated that options are more flexible that forward contracts. The use of derivatives Derivatives (2011) stated that commonly investors use derivatives for risk mitigation or hedging purposes. The most likely risk while making investments at the financial market is that the stock price might fall beyond the level where the investor bought it or the rate of exchange between two different currencies might not favor the investor, and therefore, he or she will incur loss arising from the rate of exchange. Derivatives enable the investor to cover himself by entering into a contract whereby the price at which he will purchase or sale is predetermined early in advance. Secondly, derivatives also cover investors from incurring exchange rate loss by stipulating the rate of exchange at which the purchase or sale will be applied. The second use of derivatives is for speculative purposes. Whaley (2006) stated that speculation is the opposite of hedging since in hedging investors seek to avoid or cover risk mostly attributed to exchange rate loss, while under speculation purposes, the investor expects and even seeks risk or uncovered position with the hope or making a profit from the risk taken. Therefore, if the speculator correctly predicts the market the he or she will make a profit but if the predictions are incorrect and the exchange rate moves against his or her position, the investor will incur losses. The third use of derivatives according to Shleifer and Vishny (1997) is for arbitrage purposes whereby an investor can make profit from difference in prices on related financial instruments. For example, an investor can decide to purchase foreign currency when the exchange rate is low and then purchase local currency when the exchange rate is high, and therefore, he or she will be able to make profit from the difference in exchange rates. The contribution of the derivative market to the economic function of a country According to Xiong (2001), the main economic function of the derivatives market is that it transfer risks from investors who do not prefer to take any risk to investors who are have high preference for risk. Secondly, Lewis (2008) stated that third party investors normally use information from the market as predictions for possible future outcomes. Thirdly, Durbin (2011) stated that generally, the derivatives markets are responsible for increase in investments and savings in the economy. References Boumlouka, M. (2009),"Alternatives in OTC Pricing", Hedge Funds Review, Chance, D. and Brooks, R. (2010). "Advanced Derivatives and Strategies". Introduction to Derivatives and Risk Management (8th edition.). Mason, Ohio: Cengage Learning Chicago Board of Trade (2003), Introduction to Hedging with Futures and Options: Taking Control of Your Future: Workbook Chance, D. and Brooks, R. (2008), An Introduction to Derivatives and Risk Management: (7th Edition), U.S: Thompson South-Western Publishers. Derivatives, (2011), Financial Dictionary. Available from: [24. 05.2013]. Durbin, M. (2011). All About Derivatives (2nd edition). New York: McGraw-Hill. Ferguson, N. (2008) The Ascent of Money: A Financial History of the World, U.K: Penguin Press Hull, J. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. Hull, J. (2009). Options, futures, and other derivatives. Upper Saddle River, NJ : Pearson/Prentice Hall Hull, J. (2011). Options, Futures and Other Derivatives (8th edition). Harlow: Pearson Education. Institute for Financial Markets (2011). Futures and Options (2nd edition). Washington DC: Institute for Financial Markets. Khullar, S. (2009). "Using Derivatives to Create Alpha". Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientific Lewis, M. (2008), Panic: The Story of Modern Financial Insanity, U.K: Penguin Books Liu, Q. and Lejot, P. (2013). "Debt, Derivatives and complex interactions". Finance in Asia: Institutions, Regulation and Policy. New York: London: Routledge Mattoo, M. (1997). Structured Derivatives: New Tools for Investment Management: A Handbook of Structuring, Pricing & Investor Applications. London: Financial Times Perold, F, (2004), The Capital Asset Pricing Model, Journal of Economic Perspectives, 18, 3–24. Raghuram, R. (2006). "Has Financial Development Made the World Riskier?". European Financial Management. 12 (4): 499–533 Ross, M. (1999), An Introduction to Mathematical Finance: Options and Other Topics, U.K: Cambridge University Press. Rubinstein, M. (1999). Rubinstein on derivatives. Risk Books. Shirreff, D. (2004). "Derivatives and leverage". Dealing With Financial Risk. USA: The Economist. Shleifer, A. and Vishny, R. (1997). "The limits of arbitrage". Journal of Finance 52: 35–55 SWAP, (2011), Invest Words. Available from: [24. 05.2013]. Whaley, R. (2006). Derivatives: markets, valuation, and risk management. U.S: John Wiley and Sons Wilmott, P. Howison, S. and Dewynne, J. (2002), The Mathematics of Financial Derivatives: A Student Introduction, U.K: Cambridge University Press. Xiong, W. (2001). "Convergence trading with wealth effects". Journal of Financial Economics 62: 247–292. Read More