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Capital market and derivatives 1

CAPITAL MARKET AND DERIVATIVES

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Students ID. Capital market and derivatives 2

Table of contents
Introduction3
The capital market..3
Derivatives..5
Benefits...7
Risks9
Conclusion12
Reference List...13

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Students ID. Capital market and derivatives 3

Introduction
The main driving force of the progress, which is essential for development, including
the mechanisms of the market economy, is innovation. The development of the capital market
is also subject to the general rule, and the innovations among financial instruments are
derivative financial instruments or derivatives. It is necessary to introduce the derivatives in
domestic circulations wider. The funds can be invested in many known ways: in the share
capital, in bonds and other securities, in real estate, in gold, in foreign currency and so on. But
one of the most popular ways of investing in modern developed capital markets, pursuing not
only the aim of making a profit but also insuring the capital, is the use of derivative for this
purpose. The benefits that can be got from this are countless, and the price of unawareness in
derivatives is quite high. Thus, this paper explores the peculiarities of capital market and
derivatives as a port of it, as well as analyzes the benefits and risks associated with the usage
of derivatives to make the better understanding of the derivatives and how correctly to use
them.
The capital market
The capital market is a part of a financial market where supply and demand are formed
mainly on the medium-term and long-term loan capital. It is a specific sphere of market
relations, where the object of the agreement is a money capital granted as a loan and where
supply and demand are formed on it. The form of loan capitals movement is a credit. Its main
source is funds released in the process of reproduction (the depreciation funds of companies,
some working capital in cash, income that goes for restoring and expanding production, cash
income, and savings of the general population). On the capital market loans are granted for
more than one year (Fabozzi and Drake, 2009).

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The capital market contributes to an increase in production and commodity circulation,
the capital movements within the country, the transformation of money savings into capital
investments, and the resumption of the main capital. The economic role of the market is in its
ability to combine small and scattered money, and, thus, actively influence the concentration
and centralization of production and capital. From a functional point of view, the capital
market is a system of market relations, ensuring the accumulation and redistribution of money
capital in order to ensure the reproduction process. From the institutional point of view, it is a
set of financial institutions and stock exchanges, through which a loan capital moves (Fabozzi
and Drake, 2009).
Thus, the capital market is an integral part of the financial market, that is divided into
the stock market and the medium and long-term bank loans market. It is also a major source
of long-term investment resources for the government, corporations, and banks. When a
money market provides highly liquid funds, largely to meet short-term needs, the capital
market provides long-term needs in financial resources. It covers the turnover of loan and
banking capital, the turnover of commercial and banking credits, as well as the functioning of
credit auctions (Fabozzi and Drake, 2009).
The capital market evolved from the origin on the market of simple commodity
production, in the form of circulation of usurers capital, to a wide development of the loan
capital market in the total market. The most developed capital market is considered the US
market. It is distinguishable in branching, the presence of powerful credit system and
developed securities market, in the high level of the money capitals accumulation, as well as
in the broad internationalization (Fabozzi and Drake, 2009).
The main participants of this market are primary investors (the owners of free
financial resources mobilized by banks and converted into loan capital), specialized

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intermediaries (credit and financial organizations that carry out the direct involvement
(accumulation) of funds, the converting of them into the loan capital, and its further
temporary transferring to lenders on repayment basis for a fee in the form of interest), and
borrowers (legal and physical entities and state that feel the lack of financial resources and are
ready to pay to the specialized intermediary for the right to temporary use (Fabozzi and
Drake, 2009).
The capital markets structure can be represented as the sum of the currency market,
derivatives market, insurance market, credit market and the stock market (Fabozzi and Drake,
2009).
Derivatives
The peculiarity of the global capital markets development in the last third of the
twentieth century was the emergence of a variety of rights not based on a real asset,
containing a relation, and the obligations concerning the securities themselves - derivatives.
The prerequisites for the development of the derivatives market, many experts call the
instability of international financial markets in the 1970s, causing an acute need in the
development of the financial instruments, transformation and reducing risks. As a result, the
derivatives appeared the global market of which is now the most dynamic segment of the
global capital market (Hodkins, 2014).
Under the financial derivatives understand the financial risk trade instruments, prices
of which are linked to other financial or real assets. Derivative is a standard document that
certifies the right and (or) the obligation to buy or sell the underlying asset at specified
conditions in the future. The main derivatives include futures and options on commodities,
securities, currencies, interest rates and stock indices, swaps on interest rates and currencies,
as well as forward contracts (Hodkins, 2014).

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When buying and selling derivatives, the counterparties share risks, instead of assets,
arising from these assets. The price of the derivative is defined by the movement in
commodity prices, financial instruments prices, price indices or by the differences between
the two prices. Derivatives contracts are closed by cash. Herewith, the change of ownership or
putting a definite product is not expected (Hodkins, 2014).
The derivatives objective is the fixation of future price of any asset already today,
reached by concluding a forward or futures contract, the exchange of cash flows or the
exchange of assets (swaps), and the acquisition of right, but not the obligation, to conduct the
transaction (Hodkins, 2014).
The international derivatives market is characterized by the increasing volume of
transactions with derivative instruments. It is due to the high volatility of quotations and
increasing of the losses risk in the face of declining rates. Recently, the derivatives market
replenished with new members. In addition to institutional investors, in transactions
participate management companies and corporations. The possibility of insurance and
minimization of risk of losses from a depreciation of basic financial assets on the derivatives
market helps to avoid their further devaluation and a significant reduction in the volume of
operations with them on the stock markets. The turnover of derivatives market eight times
exceeds the global GDP. According to the Bank for International Settlements, the total volume
of an international derivatives market is near 300 trillion dollars (Hodkins, 2014).
The international derivatives trade is conducted on stock exchanges and OTC. It has
led to the separation of these financial instruments on derivatives sold on stock exchanges
(percentage futures and options, currency futures and options, futures and options on indexes)
and derivatives sold outside the stock exchange (currency and percentage instruments)
(Hodkins, 2014).

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The volume of the OTC transactions on the international derivatives market
significantly exceeds the volume of stock exchanges transactions, and in the recent decades,
the share of the OTC market increased from 60% to 90%. During that time, the market
volume in absolute terms has increased 133 times. The volume of stock exchange market
grew approximately 30 times, OTC - 200. The world's largest derivatives market is a North
American (54%), followed by a fairly close in volumes European (38.71%). After the global
financial crisis in 2008, on the stock exchange market is observed a significant decline in
trade, a further stabilization and a gradual increase to 70% of pre-crisis turnover in 2013. At
the same time, the global OTC derivatives market almost did not respond to the crisis of 2008
(Hodkins, 2014).
Financial derivatives are very diverse in their characteristics liquidity, availability,
cost, and risk. Therefore, each instrument has its advantages and disadvantages (Hodkins,
2014).
Benefits
The derivatives have arisen in response to the increasing level of risk due to a
volatility of prices and offered participants of market relations the mechanisms of reducing
these risks. Thus, the main benefit of derivatives is hedging risks. The procedure of the
previous fixation of all exchange transaction conditions which would be held in the future
allows sellers and buyers become independent from the risk of changes in the market price of
the underlying instrument during the forward period. In general, term agreements enable the
division into components those risks that are inherent in the basic instruments, and
simultaneously enable redistribution of them among the participants of an agreement. It
provides the possibility to trade risk separately from the basic instruments, scilicet, to
implement the transfer of price risks (Madhumathi and Ranganatham, 2012).

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One example of the successful use of hedging to protect against potential losses can be
considered the experience of the state of Texas in the United States. In this state, insure tax
revenues from the oil companies. The share of such contributions is about a quarter of the
state treasury. As a result of falling oil prices in the mid-eighties, the state budget has missed
of $ 3.5 billion. Drawing the appropriate conclusions, in order to avoid a similar situation in
the future, experts have developed a program of tax revenue hedging using options on the
New York Stock Exchange NYMEX. Hedge was drafted in such a way that the minimum
price of oil was fixed at $ 21.5 per barrel, and when the oil price grew, was provided the
additional income to the Treasury (Scherer and Winston, 2012).
Also, the positive effect from the hedging has a Singapore Airlines Ltd. It hedges
approximately half of the volume of an aviation fuel consumed through futures contracts in
Singapore. These operations allowed the airline to save 140 million Singapore dollars in the
last fiscal year and 66 million the year before. In fact, today, the airlines of the developed
countries hedge 30-60% of fuel consumed (Fedorovoa, 2004).
Additionally, derivatives are means of insurance from which not only insurance
companies can earn but virtually anyone. Moreover, concluding agreements with financial
derivatives leads to the establishment of the prices that can observe and evaluate all society.
And this provides the information to individuals who are monitoring the market, in relation to
the real value of certain assets and the future direction of the economy development
(Madhumathi and Ranganatham, 2012).
Moreover, the benefits of derivatives over shares or other underlying assets are
plentiful. Firstly, it's a free shoulder, reaching a 1:50 ratio at many marketplaces. Secondly,
financial derivatives allow earning both on the increase and decrease in the value of the
instrument. Besides, playing on the decrease does not require additional expenses as on the

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stock market. Third, using derivatives, it is possible to make a profit even from stagnation on
the stock market. Finally, the derivatives market is attractive for its low costs (the absence of
the depositary services payment and the lower commission charged by the exchange and
brokers) (Madhumathi and Ranganatham, 2012).
One of the most popular and successfully used types of derivative financial
instruments are credit derivatives. The main advantage of using credit derivatives is the
opportunity to create more efficient banking portfolios, from the side of the bank as the end
user that envisages the reduction of transaction costs and from the side of the expenses
associated with owning the underlying asset. In addition to market risk management, it can
serve as an instrument to attract additional investments in the project, when the bank for
whatever reasons (e.g., because of the threat of default or regulatory authorities restrictions) is
temporarily unable to purchase the asset (Madhumathi and Ranganatham, 2012).
The Derivative pricing theory is based on the assumption that the function of
derivative payments can be reproduced by constructing an appropriate portfolio of underlying
assets and risk-free instrument (bank account). Therefore, it requires a dynamic trade (i.e., it is
necessary to review the structure of the portfolio when market conditions change). Thus, the
derivatives make market being full (add a new payment structure that cannot be reproduced
with the help of existing assets) and, thus, add new capabilities to the financial system
(Bouchaud and Potters, 2009).
Risks
With the emergence of forms of exchange trade, the derivatives created favorable
conditions for speculative operations. In futures stock exchanges, the accessibility for the all
interested is seen as a basic rule of activity organization and a guarantee of high liquidity and
viability of exchange contracts. Such approach can significantly expand the number of

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participants, which can be not only legal entities (banks, corporations, investment funds,
insurance companies, pension funds) but also individuals. The organization of stock exchange
trading forms strongly simplifies the speculative operations, allowing concluding agreements
in large volumes at any time, and from another side, allowing stock speculators guarantee
their forecasts and carrying out speculative operations to obtain profit from price differences
(Madhumathi and Ranganatham, 2012).
In the terminal market, speculators take on the hedgers risk (a risk of changes in a
price of the underlying instrument during the forward period) in the hope that their formed
expectations will be correct and will allow getting profit. It is clear that forecasts are not
always translated into reality, and, therefore, speculators can also lose what happens
frequently in practice. By some estimates, speculators lose over 75% of the money on the
foreign exchanges as a result of transactions with derivatives (Madhumathi and Ranganatham,
2012).
As an example of risks associated with derivatives and failing speculation can be
Orange County. After the state of California reduced funding of counties, the Orange County
became strongly depended on investments in order to obtain revenue. It invested in many
derivatives, speculating that the interest rate would stay the same or even lower. After that, it
began to purchase fixed income in the long position. Ultimately, the interest rates grew rising
borrowing costs and lowering the long positions price. In short time, the Orange County
became a bankrupt being incapable to fulfil its obligations. Totally, it lost near $1.7 billion
from such speculation (Hodkins, 2014).
The derivatives are subject to certain risks, such as credit, market and legal. These
types of risks are not new, but using the derivatives incorrectly can multiplex them repeatedly.
The credit risk is one of the main risks inherent in financial derivatives. Besides the

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probability of default of the underlying asset, can also default a seller of protection. In this
case, the buyer of protection bears a double loss. In practice, the probability of a simultaneous
default on both transactions is extremely low, but it cannot be ignored. For example, the
probability of a simultaneous default increases significantly, when the underlying asset and
the seller of protection are in the same area or are related to the same industry. Additionally,
the market risk also influences the cost of protection because the decline in market quotations
of the underlying asset leads to an increase in credit spread, and, in some cases, may be
considered as a credit event (Madhumathi and Ranganatham, 2012).
The market risk is speculative, so it is necessary to envisage only the negative versions
of its manifestation (rating downgrade of the protection seller and caused by this temporary
financial difficulties, changes in exchange rates (if the derivative agreement provides for the
use of different currencies in relation to the exchange rate), decline in general regional or
sectoral quotations of securities, etc) (Madhumathi and Ranganatham, 2012).
Special attention deserves the legal risk. The history and reputation of the counterparty
may be uncertain. This factor relates to the market and to the legal risk. To the legal risks are
directly related such factors as incomplete or insufficiently clear definition of the terms of the
deal, disregard for likelihood of a merger or acquisition of a credit protection seller with the
occurrence of difficulties in the implementation of previous agreements, and the unprescribed
conditions of debt restructuring of the credit protection seller to the buyer in case of a credit
event (Madhumathi and Ranganatham, 2012).
The Derivative pricing theory suggests that derivatives, theoretically, do not bring the
financial system anything new, and, therefore, are redundant instruments. Thus, derivatives
can be reproduced by building a portfolio of existing assets, and, thus, from the economic
point of view, are excessive instruments (Bouchaud and Potters, 2009).

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Conclusion
In conclusion, the use of derivatives provides for economic operators numerous
advantages, the main of which is the transformation of the financial risk considering the
specified parameters of management strategy. In this sense, the rapid pace of development of
the derivatives industry and the increasing complexity of new products placed on the market
primarily reflect the demand from the end-users who are interested in the use of derivatives,
and innovative resources of the financial sector that is able to respond quickly to the dynamic
changes in that demand. At the same time, the use of derivatives is justified only under the
condition when the managers of the company or financial institution are fully aware of the
potential risks of specific operations. Although at transactions with derivative financial
instruments arise risks of standard varieties, their practical manifestation can take new forms.
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Reference List
Bouchaud, J & Potters, M 2009, Theory of Financial Risk and Derivative Pricing: From
Statistical Physics to Risk Management, 2nd edn, Cambridge University Press, Cambridge.

Fabozzi, JF & Drake, PP 2009, Finance: Capital Markets, Financial Management, and
Investment Management, John Wiley & Sons, Inc., New Jersey.

Fedorovoa, TA 2004, Airline Indemnity Against Liability, viewed 17 February 2016,

<http://the-books.biz/about-insurance/airline-indemnity-against-59545.html>

Hodgkins, JD 2014, Usage of Derivatives in Business Today, Honors Scholar Theses, viewed
17 February 2016, <http://digitalcommons.uconn.edu/cgi/viewcontent.cgi?
article=1348&context=srhonors_theses>

Madhumathi, R & Ranganatham, M 2012, Derivatives and Risk Management, Dorling

Kindersley Pvt. Inc., New Dehli.

Scherer, B 2012, The Oxford Handbook of Quantitative Asset Management, Oxford

University Press, Inc., New York.

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