The chapter is structured on the basis of the research questions these are the

The chapter is structured on the basis of the

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factors necessary for the development of financial derivatives markets. The chapter is structured on the basis of the research questions: these are, the legal and regulatory framework influence growth of derivatives markets, out the extent to which risk management influence the growth of derivatives market in Kenya & the extent of financial derivatives information gap and its impact on development of derivatives markets Kenya. 2.2 Theoretical Review A theory is viewed by Cooper and schindler (2008) as a set of systematic interrelated concepts, definitions and propositions that are advanced to explain and predict a phenomena 13
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or facts. According to this study, the theoretical review will involve other scholar’s theory about risk management, information gaps and legal and regulatory framework. This guided the study in terms of conceptual framework. 2.2.1 Portfolio Theory Harry M. Markowitz published in 1952 a path-breaking article (Markowitz, 1952) which he expected in 1991, argued that the traditional application of one-dimensional investment criteria such as the Net Present value (NPV) criterion should be replaced by two dimensions: Expected returns and risk, defined as the standard deviation of the return distribution. He argued also that investors should not look at securities individually. It is unrealistic to assume that investors or investment advisors can predict the future return of individual stocks. However, based on empirical analysis of the co-variation of the returns of several securities, it is possible to make portfolio judgment, in which the imperfect correlation between the securities can be exploited for diversification. The focal of investors should be on the effect of combining securities. In a realistic setting, investors must make a trade-off between expected returns and risk. The available investment globally constitutes an efficient frontier with a slope shape which reflects the interchange in the financial market between all investors with a dissimilar degree of risk-aversion. If an individual investor wants a higher expected return, he must accept a higher risk. In 1993-1994, J.P. Morgan revised their technical paper and popularized the concept of Value-at-Risk (VaR) as portfolio risk measure to be applied by financial markets in the capital adequacy calculations to be presented to financial regulators. VaR is a measure estimated by means of historical statistics on volatility and correlations among a sample of financial assets and focusing on the probability of incurring losses. For a given portfolio, probability and time horizon, VaR is defined as a threshold value, which can be used to guide the portfolio managers to keep the probability of suffering losses below a certain level. 2.2.2 Theory of Market Microstructure Derivatives markets is based on the theory of market micro structure which is a field in financial economics and concerned with the details of how securities exchange occurs in markets, most commonly financial markets. Market microstructure deals with market 14
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structure issues, design, price formation and price discovery, transaction and timing cost,
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