Derivative Product
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Derivative Product
Derivatives play a major role in the management of risk to both financial and non-financial organizations. In the present era, derivative market operations have been confirmed to destabilize financial markets’ efficiency. Forward contracts, swaps, options, futures contracts, and other combinations are being used by the current financial and non-financial companies with the aim of increasing returns and reducing risk. The acute growth of derivatives markets open for an understanding that the market demand for derivatives has increased in the economy (Bessis, 2015). A common and emerging concern in the market is the component of over the counter (OTC) derivatives attracting interest rates and swaps. Any major fault in the derivative market or misuse of derivatives will cause a suffering to the economy.
Forms of Traded Derivatives Settled
Over-the-counter Derivatives (OTCs)
The counterparties meet and agree on terms and conditions between buyer and seller during the exchange. The major reason why over-the-counter contracts are more illiquid such as swaps and forward contracts. An over the counter market trades on over-the-counter derivatives. The market is dominated by investment banks and other clients like hedge funds, government-sponsored businesses, and commercial banks. Products traded over the counter include forward contracts, forward rate agreements, credit derivatives, and swaps. The trade derivatives’ value highly depends on the underlying asset value. Before entering such agreements, the parties involved determine the exchange rate or the asset value to be delivered in future.
Exchange-Traded Derivatives (ETDs)
Exchange-traded contracts have standardized forms of order where a recognized exchange between the counterparties are only the exchange and the holder of the derivative. The terms of meeting an exchange-traded derivative are non-negotiable and prices are publicly made available. Derivatives were set to be used by pension schemes by the Finance Act of 1990 without making any tax implications. Upon major investigations, OTC assets are excluded from major by the Local Government Pension Schemes and pension fund trustees during the seek of advisory admissibility. In the past, OTC derivative contracts were non-cleared and settled between involved parties. Payments were made to the other party directly without undergoing prolonged procedures (Acharya, & Bisin, 2014). The parties transacting were considered to take risks for one another by;
Having quality counterparts
An adaptation of credit risk measures like a cross-default
Having credit support annex to collateral liabilities
OTC derivatives are classified as bilateral contracts though they can be subject to splitting and novation during the clearing process, trading of exchanges, and in the clearance of houses (Valdez, & Molyneux, 2015).
Settlement of Derivative Product
Settlement of a derivative requires parties involved to obtain items contracted. Usually, the two parties are involved in derivatives. One party must bring cash while the other the securities. The parties must avail themselves with the requirements within the contract time. Upon expiry, the defaulting party must pay for penalties and any losses attached to the failure of meeting deadlines. Clearing is a process where the management does a post-transaction activity to ensure every transaction has been settled well (Iyer, Anguish, Hadi, & Patel, 2015). In the traditional times, only traded derivatives could be cleared but the financial crisis that hit the world caused an introduction of regulations requiring over-the-counter transactions to be cleared. Risk obligations must be signed by one party to be delivered to another. In an exchange-traded derivative, multiple instances of securities or cash deliveries between involved parties exist during the period of the transaction (Lam, 2014). When there are multiple instances, repeated clearance transactions are required to settle the process.
Credit Derivatives Settlement
Credit derivatives help purchasers in protecting themselves against possible credit events with reference to a transaction. However, a credit event does not guarantee a trigger of a credit derivative transaction. A confirmation of a settlement is achieved when parties involved consent to the application f their transaction. The applications of transactions can be done through auction, physical or cash (Baldeaux, & Badran, 2014).
Physical Deliveries Derivatives
A physical delivery of a derivative is a way where futures or options contracts that require the underlying assets must be delivered on the specified date instead of trading them with offsetting contracts. Contracts settled with cash require the delivery of the net cash before the expiry date when the transfer of the derivative between the seller and the buyer takes place. The delivery conditions for contracts are specified on what to be covered. Warehouses and delivery locations are designated for various commodities. Deliveries are made with bearer receipts or warrants representing either the quality, quantity, or both of the commodities. A periodic fee is charged on buyers who opt to leave their commodities at the warehouses. Despite having delivery dates, the exercise of many derivatives does not occur because they get traded before the delivery date. But physical deliveries occur in other trades such as bonds and commodities. The settlement of physical delivery is completed by agents or clearing brokers.
The derivative of Market Equity
A market equity derivative comprises of financial instruments such as swaps, options, and futures. Stocks and stock indices with prices depending on underlying equity instruments are forms of equity derivatives. Equity derivatives take the form of trade where over the counter markets or futures and options exchanges are used. However, the commonly used derivative market equity are the options and futures. Futures and options give sellers or buyers the right and not the obligation of selling or buying underlying assets with set fixed prices for the future. A market value must be determined for such participants to be able to sell or buy the underlying assets. A call option guarantees a right of buying an underlying asset while the put option issues a right to sell the underlying asset. The purchaser of a call option has higher chances of gaining through an increase in the price of the asset without purchasing it. On the other hand, a put option holders gain benefits when a fall in the price of an underlying asset occurs. Among the categories, future contracts have a standardization criterion unlike options and their trades are accredited exchanges.
Similar products offered in the same exchange
Option(s) Contract
The futures option are the best form of trading future markets. New entrants into the market commence with trading on futures option rather than the straight futures contracts. In using options, less volatility an risk are experienced unlike the use of futures. Professional traders trade on Option (Dionne, 2013).
Futures Option
Having an option is a right yet not an obligation of buying or selling a futures contract at set strike prices. To avoid higher future prices, traders are advised to buy option due to fluctuations in future that may be low or high. The major forms of an option are calls and puts.
Convertible Bonds
A combination of equity and bonds creates convertible bonds. Convertible bonds offer security to bonds, help in generating more returns, and their volatility is less. Convertible bonds allow investors of equity derivatives to hedge the possible risks associated with their investments. Apart from hedging, equity derivatives can act as speculative instruments when a need arises (Soin, & Collier, 2013). The stock data and derivatives are used by equity market traders in making decisions on the best options to take at different stages and prices.
Calls – When the future prices are known to move higher call options are the best forms of trading. If a bond is deemed to go higher, a trader can buy a present cal option to avoid higher prices in the future.
Puts – Certain bond prices remain lower in the predetermined future. In such circumstances, a put option should be made to take advantage of future lower prices.
Premium – A premium is a payment of some amount when buying an option. Such a price is considered as a bet to confirm an engagement to fulfill an agreed term. When making an option premium, a big long shot leads to a less expensive price. However, when a bet is sure, its value increases hence becomes more expensive (Kozhan, Neuberger, & Schneider, 2013).
Contract Time – Options like other trade products have expiry dates. A contract time on derivatives indicates that they have specified periods of tie to be traded beyond which no transaction relating to them can be done. An option bought can never be held forever but within the agreed period and it is sold.
Swaps
Swaps are agreements made between two parties in an exchange for future cash flows. Within the agreement, dates for the cash flows are defined and manner of calculations determined. The chosen formula or method of determining paid amounts must be put in a document to avoid future declines or refusal to submit payments. Swaps can be exercised in two forms that are currency swap or interest rate swap.
Benefits of Swaps
The exposure to interest rates is regulated by portfolio managers
The benefit is drawn by speculators from interest rates changes favoring one party
The uncertainty of future cash flows can be managed by companies through the modification of debt conditions
Risks and costs associated with currency exchange are reduced
Floating-rate swaps can be capitalized by companies with fixed rate liabilities
Limitations of Swaps
Companies or parties involved are exposed to credit risk
The central government intervention has an effect on the exchange markets
Conclusion
Derivatives help businesses discover prices in the market for the present and future. Transparency and accountability are enhanced when standards used within an industry are applied in the world. Investors move from one country to another making investments that can generate returns in the future. The determination of prices can be based on climatic conditions, debt default, political situations, land reclamation, and environmental health. The future markets of some items or securities are determined to prepare traders for future business conditions that can be controlled. Investors and traders focus on the future when making investment decisions in business (Voit, 2013). Making future expectations clearly made in a better time an help manager to identify future market trends and set in place. Risk well forecasted can be managed and handled before they affect securities and bonds that governments and individuals are involved. Derivatives are economical tools that determine the economic state of a market or a state depending on the underlying features. Market efficiency can be improved through early and proper planning where future forecasts can be used to determine the amount to invest when to invest, and where such investments can be made. The costs of implementing investment strategies can be a major milestone in the placement of future returns from the purchased or sold derivatives such as bonds or securities. Insights supporting the board of directors (BOD) are made through a proper risk management exercise among the board members. A risk prevention program well implemented by a management team can help in getting credit for a cooperation. Despite being impossible to avoid the risk of various potential challenges, setting of regulations using better choices of derivatives and investment in bonds. Legal regulations are issues that must be implemented by every organization or individual performing business of trading in a market where conditions are favorable.
References
Acharya, V., & Bisin, A. (2014). Counterparty risk externality: Centralized versus over-the-counter markets. Journal of Economic Theory, 149, 153-182.
Baldeaux, J., & Badran, A. (2014). Consistent modelling of VIX and equity derivatives using a 3/2 plus jumps model. Applied Mathematical Finance, 21(4), 299-312.
Bessis, J. (2015). Risk management in banking. John Wiley & Sons.
Dionne, G. (2013). Risk management: History, definition, and critique. Risk Management and Insurance Review, 16(2), 147-166.
Iyer, S., Anguish, K., Hadi, M., & Patel, K. (2015). U.S. Patent Application No. 14/627,627.
Kozhan, R., Neuberger, A., & Schneider, P. (2013). The skew risk premium in the equity index market. The Review of Financial Studies, 26(9), 2174-2203.
Lam, J. (2014). Enterprise risk management: from incentives to controls. John Wiley & Sons.
Soin, K., & Collier, P. (2013). Risk and risk management in management accounting and control.
Valdez, S., & Molyneux, P. (2015). An introduction to global financial markets. Macmillan International Higher Education.
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