TASK 1:

An Overview of Financial Derivatives:

A derivative is basically a contract between two or more entities. This contract is based on
some agreed upon sets of financial assets. The financial derivatives derive their value from the
value of the assets underlying them because the value and characteristics of these financial
assets depend on the value and characteristics of the assets on which they depend. Some
common underlying financial assets include security, index, bonds, currencies, stocks, interest
rates and commodities. The financial derivatives play an important role in discovering the
future prices as well as the current prices. With the help of the financial derivatives the risk can
be transferred from risk aversive people to the risk oriented people. As there are larger number
of risk aversive people in the market so the financial derivatives also helps in increased trade
activities of markets. The financial derivatives can catalyze the activities of an entrepreneur
along with increased number of savings in the long run.

History of Financial Derivatives:

The basis of the financial derivatives markets are from the middle ages. The financial derivatives
were basically developed for fulfilling the needs of the merchants and farmers of middle ages.
The first financial derivative market was developed in 1848 and was named as The Chicago
Board of Trade. It was developed to bring together the farmers and merchants. At the
beginning the financial derivatives were used to standardize the quality and quantity of the
grains that were going to be traded. After some years of this trade the first type of future
contract was developed. It was named as to-arrive contract.

Types of Financial Derivatives:

1) Forward Contract:
An agreement between two counter parties including a buyer and a seller is a forward
contract. The seller is agreed to sale a particular asset and the buyer is willing to buy
that particular asset from the seller. The price of the asset is determined at the time of
purchase but the delivery of that asset may be at a later time.
Features of forward contract:
The basic features of forward contracts are given as:
 The forward contracts are bilateral and that is why these contracts are exposed
to counter party risk.
 Every contract of this category are unique regarding to the type of the contract,
expiry date of the contract, size of the contract, type of the contract and lastly

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 the quality of the contract. These contracts are mainly designed by the
customers.
 The prices of these contracts are not available in domain of general public.
 The expiration date has to be decided according to the delivery of the asset.
 The contract can be reversed if any party wishes to do this.

Limitations of the forward contract:

Some basic limitations of forward contracts are as follows:

 In forward contracts there is a lack of centralization for trading
 There are a lot of chances of counterparty risk and liquidity in forward contracts
 There is a lot of generality and flexibility in forward contracts
 If any party plays a faulty role in the transaction then counterparty risk occurs
 If any of the two parties declared bankruptcy, the other party also suffers

2) Future Contract:
A future contract is that type of agreement in which the price is determined at the time
of contract as well as the delivery date is also settled. These future contracts also
require a party to sell the asset and a party to purchase the asset. Future contracts are
mainly of two types
I. Commodity Future Contracts: The commodity future contracts involve the
contracts related to the traditional commodities of agriculture including the
livestock and grains and food stuffs that are used in import and export such as
sugar, cocoa and coffee.
II. Financial Future Contracts: The financial future contracts include the financial
contracts.

Features of Future Contract:

The future contracts are used by the speculators and hedgers. It is a legal agreement of
a company between a purchaser and the seller to take the delivery of the asset at a
specified time and at a determined price. The prices that is settled and the parties are
agreed upon the price is called the future price. The date that is settled and determined
between the parties to deliver the asset is called settlement date. Mostly the future
contracts have dates of settlement in the months of March, June, September and
December. The contracts having the close date of settlement is called the nearby future
contract and the contracts having far date of settlement is called the distant future
contract.

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 Limitations of future contracts:
Some basic limitations of future contracts are as follows:
 The most basic limitation of the future contracts is that there is no control on the
investments because of over control future events. Moreover political issues,
natural disasters and unexpected weather conditions also disturb the
equilibrium of demand and supply.
 Future prices are highly fluctuated by the high leverage
 The future contract prices may become less attractive because of the late future
settlement dates.
3) Options:

The third basic instrument of financial derivative is the option. It is a contract between the
buyer and the seller to sell or buy an asset on a specified price that is fixed and the asset is
handover before the expiration of the contract. There are two basic types of option that are as
under:

I. Call option: According to the call option the holder has the right to buy any asset on a
specified price in a specific time period or specified time or date.
II. Put option: According to the put option the holder has the right to sell any asset on a
specified price in a specific time period or specified time or date.

Advantages of Financial Derivatives:

Some of the basic advantages of financial derivatives are:

 As the values of the derivatives are related to the value of the assets so they can be
used for hedging risks.
 Financial derivatives are helpful in determining the prices of the underlying assets.
 Financial derivatives help in increasing the efficiency of the financial markets.
 Financial derivatives are also helpful in accessing the unavailable assets and markets.

Disadvantages of Financial Derivatives:

 The financial derivatives are highly volatile that is why they may cause huge
potential losses.
 Financial derivatives are extremely risky and are unpredictable that is why they
may cause huge losses.
 Sometimes the counter parties also cause huge losses.

Role of Financial Derivatives In Financial Crisis:

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Everyone knows about the downfall of the world’s economy that was held in 2008 because of
the financial crisis. In case of the financial derivatives it was considered that the options
financial derivatives are one of the main causes of the crisis of 2008 because of the downfall in
their values which was not fulfilling the requirement of the repayments of the loans. The credit
default swaps were sold as the insurance against the defaulted municipal bonds that
contributed a lot in the financial crisis of 2008.

TASK 2:

Financial Structures:

Structure is basically the arrangement of different parts in an order. The financial structure
means the arrangement of the finance which is collected from different resources to manage
the long term business activities. So the financial structure refers to the combinations and
proportions of the long term and short term composition of the debts. Some of the basic
features of the financial structure are given as:

 The financial structure helps in increasing the value of a firm in the market place with
the help of shares and securities.

 The financial structures play an important role in the utilization of the available funds as
to fulfill the requirements of the firm.

 The financial structure also helps in maximization of the return of the by increase in
earnings per share.

 The financial structure also determines the minimization of the cost of capital as the
interest on the debt is tax deductable.

 Flexibility and liquidity position of a firm is increased by the financial structure of the
firm.

 Financial structures helps in minimizing the financial risks for the firm. A healthy
financial structure helps in protecting the business enterprise from the financial risks.

 A good financial structure never allows the equity share holders to dilute the business.

Factors Determining the Financial Structure:

Some factors that are determining the financial structure are given as:

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  The financial structure is influenced by the risk of insolvency of the cash because the
company has to pay higher rate of interest on the debts despite of the facts that either
the funds are available or not.

 The financial structure is also influenced by the risks that are held because of the
variations in the earnings because if the return on the investments on total employed
capital increased the rate of interest then the returns of the share holders increased.

 The cost of capital is the cost of increase in the funds of the company from different
resources also affects the financial structure and stability of a company.

 The financial structure is also affected by the policies of the government. Fiscal and
monetary policies of the government affect the financial structure of the company.

 The financial structure is greatly influenced by the size of the company

 The financial structure is also depending on the number of investors of the company.

 The time period for which the finance is required also affects the financial structure of
the company

 The financial structure of the company must be flexible

 The financial structure is also based on the nature of the business long with the legal
requirements that are needed for the business.

The financial sector plays an important role in the economy of a country because the financial
sector is composed of financial instruments that ensure the financial intermediaries. These
financial intermediaries include the channeling of the funds from the investors to the savers
and savers to the investors. A healthy and efficient financial sector of an economy helps in
encouraging the accumulation of the reserves and savings along with that they also helps in the
process of allocation of the funds to the most productive investments with the help of
innovation and boost in the economic growth.

Relationship between Financial Stability and Banking Market Structure:

Financially stability is a unique property which helps in balancing the financial conditions that
may arise because of the unpredictable events. So the financial stability is very important for
the maintenance of confidence in the economy. Financial stability is very important for its
relationship with banking sector as if it works smoothly it will help in controlling the economic
burden and decreases the chances of the dearth of money. The financial stability describes that
condition of the financial intermediaries where the financial functions can work properly and

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smoothly with other financial institutions and financial markets of the economy. It is a property
of the financial system which helps in creating a balance between the inflow and outflow of the
finance in the economy. If the economy if financially stable then the economy is able to bear
the shocks with the help of self created mechanisms without disturbing the real economy. It is a
paramount which helps in economic growth in the real economy which is done by the financial
structure of the economy.

Banks are considered as the main financial intermediaries in the world. The credits of the banks
are also used as fulfilling the financial needs of the common people along with the businesses.
Banking credits also helps in financing for improving the patterns of consumption of the people
and also for investing in real estate markets. If there is no financial stability in the economy of a
country the banks are reluctant to finance or invest in the projects because of the deviations in
the currency. So the financial stability is important for maintaining the confidence of an
economy.

TOTAL NUMBER OF WORDS: 2006

REFERENCES:

1.1) . eFinanceManagement.com. (2019). Derivatives | Definition, Types - Forwards, Futures, Options,

Swaps, etc. [online] Available at: https://efinancemanagement.com/derivatives [Accessed 20 Apr.
2019].
1.2) 5paisa.com. (2019). Different Types of Derivative Contracts. [online] Available at:
https://www.5paisa.com/articles/different-types-of-derivative-contracts [Accessed 20 Apr. 2019].
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_CRISIS [Accessed 20 Apr. 2019].
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_in_India-A_Case_Study [Accessed 20 Apr. 2019].
1.5) Booktele.com. (2019). An Introduction To Management Science 13Th Edition Solutions Pdf. [online]
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1.6) Investopedia. (2019). Derivative. [online] Available at:
https://www.investopedia.com/terms/d/derivative.asp [Accessed 19 Apr. 2019].
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Prices. [online] Papers.ssrn.com. Available at:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2391346 [Accessed 21 Apr. 2019].
1.8) The Balance. (2019). How Derivatives Could Trigger Another Financial Crisis. [online] Available at:
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Apr. 2019].

2.1) Digitalcommons.law.umaryland.edu. (2019). [online] Available

at:https://digitalcommons.law.umaryland.edu/cgi/viewcontent.cgi?referer=https://www.google.com/&httpsr
edir=1&article=1036&context=cong_test [Accessed 20 Apr. 2019].

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2.2) Stunda, R. (2019). The Role of Derivatives in the Financial Crisis and Their Impact on Security
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https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2391346 [Accessed 20 Apr. 2019].

2.3) World Bank. (2019). Key Terms Explained. [online] Available at:
http://www.worldbank.org/en/publication/gfdr/background/key-terms-explained [Accessed 19 Apr. 2019].

2.4) Your Article Library. (2019). Capital Structure: Meaning, Concept, Importance and Factors |
Accounting. [online] Available at: http://www.yourarticlelibrary.com/financial-management/capital-
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Apr. 2019].

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 WORK DECLARATION

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