Definition of Financial Derivatives

1. A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed- pon benchmar!. ". #ince a financial derivative can be created by means of a m t al agreement, the types of derivative prod cts are limited only by imagination and so there is no definitive list of derivative prod cts. $. #ome common financial derivatives, however, are described later. %. &ore generic is the concept of 'hedge f nds( which se financial derivatives as their most important tool for ris! management.

)epayment of Financial Derivatives

*n creating a financial derivative, the means for, basis of, and rate of payment are specified. +ayment may be in c rrency, sec rities, a physical entity s ch as gold or silver, and an agric lt ral prod ct s ch as wheat or por!, a transitory commodity s ch as comm nication bandwidth or energy. ,he amo nt of payment may be tied to movement of interest rates, stoc! inde-es, or foreign c rrency. Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed. .everaging th s acts to m ltiply (favorably or nfavorably) impacts on total payment obligations of the parties to the derivative instr ment.

/ommon Financial Derivatives

0ptions Forward /ontracts F t res
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 #tripped &ortgage-1ac!ed #ec rities #tr ct red 2otes #waps )ights of 3se /ombined 4edge F nds

0ptions
,he p rchaser of an 0ption has rights (b t not obligations) to b y or sell the asset d ring a given time for a specified price (the "#tri!e" price). An 0ption to b y is !nown as a "/all," and an 0ption to sell is called a "+ t." ,he seller of a /all 0ption is obligated to sell the asset to the party that p rchased the 0ption. ,he seller of a + t 0ption is obligated to b y the asset. *n a '/overed( 0ption, the seller of the 0ption already owns the asset. *n a '2a!ed( 0ption, the seller does not own the asset 0ptions are traded on organi5ed e-changes and 0,/.

Forward /ontracts
*n a Forward /ontract, both the seller and the p rchaser are obligated to trade a sec rity or other asset at a specified date in the f t re. ,he price paid for the sec rity or asset may be agreed pon at the time the contract is entered into or may be determined at delivery. Forward /ontracts generally are traded 0,/.

F t res
A F t re is a contract to b y or sell a standard 6 antity and 6 ality of an asset or sec rity at a specified date and price. F t res are similar to Forward /ontracts, b t are standardi5ed and traded on an e-change, and are val ed daily. ,he daily val e provides both parties with an acco nting of their financial obligations nder the terms of the F t re.

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 3nli!e Forward /ontracts, the co nterparty to the b yer or seller in a F t res contract is the clearing corporation on the appropriate e-change. F t res often are settled in cash or cash e6 ivalents, rather than re6 iring physical delivery of the nderlying asset.

#waps
A #wap is a sim ltaneo s b ying and selling of the same sec rity or obligation. +erhaps the best-!nown #wap occ rs when two parties e-change interest payments based on an identical principal amo nt, called the "notional principal amo nt." ,hin! of an interest rate #wap as follows7 +arty A holds a 18-year )#.18, 888 home e6 ity loans that has a fi-ed interest rate of 9 percent, and +arty 1 holds a 18-year )s.18, 888 home e6 ity loans that have an ad: stable interest rate that will change over the "life" of the mortgage. *f +arty A and +arty 1 were to e-change interest rate payments on their otherwise identical mortgages, they wo ld have engaged in an interest rate #wap. *nterest rate swaps occ r generally in three scenarios. ;-changes of a fi-ed rate for a floating rate, a floating rate for a fi-ed rate, or a floating rate for a floating rate.

/ombined Derivative +rod cts

,he range of derivative prod cts is limited only by the h man imagination. ,herefore, it is not n s al for financial derivatives to be merged in vario s combinations to form new derivative prod cts. For instance, a company may find it advantageo s to finance operations by iss ing debt, the interest rate of which is determined by some nrelated inde-. ,he company may have e-changed the liability for interest payments with another party. ,his prod ct combines a #tr ct red 2ote with an interest rate #wap.

4edge F nds
A 'hedge f nd( is a private partnership aimed at very wealthy investors. *t can se strategies to red ce ris!. 1 t it may also se leverage, which increases the level of ris! and the potential rewards. 4edge f nds can invest in virt ally anything anywhere. ,hey can hold stoc!s, bonds, and government sec rities in all global mar!ets. ,hey may p rchase c rrencies, derivatives, commodities, and tangible assets. ,hey may leverage their portfolios by borrowing money against their assets, or by borrowing stoc!s from

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investment bro!ers and selling them (shorting). ,hey may also invest in closely held companies. #ome investors se hedge f nds to red ce ris! in their portfolio by diversifying into ncommon or alternative investments li!e commodities or foreign c rrencies. 0thers se hedge f nds as the primary means of implementing their long-term investment strategy.

2eed of Derivatives
1. Derivatives are ris!-shifting devices. *nitially, they were sed to red ce e-pos re to changes in s ch factors as weather, foreign e-change rates, interest rates, or stoc! inde-es. ". For e-ample, if an American company e-pects payment for a shipment of goods in 1ritish +o nd #terling, it may enter into a derivative contract with another party to red ce the ris! that the e-change rate with the 3.#. Dollar will be more nfavorable at the time the bill is d e and paid. 3nder the derivative instr ment, the other party is obligated to pay the company the amo nt d e at the e-change rate in effect when the derivative contract was e-ec ted. 1y sing a derivative prod ct, the company has shifted the ris! of e-change rate movement to another party. $. &ore recently, derivatives have been sed to segregate categories of investment ris! that may appeal to different investment strategies sed by m t al f nd managers, corporate treas rers or pension f nd administrators. ,hese investment managers may decide that it is more beneficial to ass me a specific "ris!" characteristic of a sec rity.

,he )is!s
#ince derivatives are ris!-shifting devices, it is important to identify and nderstand the ris!s being ass med, eval ate them, and contin o sly monitor and manage them. ;ach party to a derivative contract sho ld be able to identify all the ris!s that are being ass med before entering into a derivative contract. +art of the ris! identification process is a determination of the monetary e-pos re of the parties nder the terms of the derivative instr ment. As money s ally is not d e ntil the specified date of performance of the parties< obligations, lac! of pfront commitment of cash may obsc re the event al monetary significance of the parties< obligations. *nvestors and mar!ets traditionally have loo!ed to commercial rating services for eval ation of the credit and investment ris! of iss ers of debt sec rities.
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 #ome firms have beg n iss ing ratings on a company<s sec rities which reflect an eval ation of the e-pos re to derivative financial instr ments to which it is a party. An often overloo!ed, b t very important aspect in the se of derivatives is the need for constant monitoring and managing of the ris!s represented by the derivative instr ments. For instance, the degree of ris! which one party was willing to ass me initially co ld change greatly d e to intervening and ne-pected events. ;ach party to the derivative contract sho ld monitor contin o sly the commitments represented by the derivative prod ct. Financial derivative instr ments that have leveraging feat res demand closer, even daily or ho rly monitoring and management.

1ibliography
www.google.com www.wi!ipedia.org

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