Introductory-Notes-on-Derivative-Securities-Fall-2009-SfR -...

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Fin 480 (Fall 2009) Faculty: Saif Rahman (SfR) DERIVATIVE SECURITIES Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk. Meaning and definition In finance, a derivative is a financial instrument derived from some other asset; rather than trade or exchange the asset itself, market participants enter into an agreement to exchange cash, assets or some other value at some future date based on the underlying asset. The term derivatives indicates that it has no independent value ie., its value is entirely derived from value of underlying asset. The underlying asset can be securities, commodities, bullion, currency, interest rates, indices, live stock etc. Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. There are many types of financial instruments that are grouped under the term derivatives, but options/futures and swaps are among the most common.
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Fin 480 (Fall 2009) Faculty: Saif Rahman (SfR) BASIC FEATURES OF DERIVATIVES 1. As derivatives are not physical assets, transactions are settled by offsetting/squaring transactions. The difference in value of derivative is cash settled. 2. There is no limit on the number of units transacted in the derivative market because there is no physical asset to be transacted. 3. Derivative markets are usually computerized. 4. Derivatives are secondary market securities and cannot help in raising funds for a firm. 5. Derivative market is quite liquid and transactions can be effected easily. 6. Derivative provides hedging against different risks. The participants in a derivatives market Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs
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Introductory-Notes-on-Derivative-Securities-Fall-2009-SfR -...

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