Derivative What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Managing Financial Risks with Derivatives: The case of the UK Telecommunications Industry Abstract The increased volatility of the financial markets, has given rise to increased financial price risks faced by companies. Companies are now exposed to risks caused by unexpected movements in exchange rates and interest rates. With the growing global presence of the telecommunications industry, the companies in these industries are exposed to a wide range of financial risks, in particular foreign exchange risks and interest rate risk. The management of these risks has become paramount for the survival of companies in todays volatile financial markets. 1http://ww.masterpapers.com Dissertation and Thesis writing service 1.0. Introduction Over recent decades, the financial markets have become more volatile due to significant changes, which have taken place in the domestic and international financial markets. In the post war period, managers of corporations worried little about foreign exchange rate and interest rates, as interest rates were fairly stable and the fixed exchange rates of the Bretton Woods era allowed companies know with great certainty the

amount of home currency it expected to pay for imports. However since the 1970s changes occurred. After the collapse of the Bretton Woods system and the move to generalized floating among the major exchange rates, it soon became clear that large movements in exchange rates were occurring far more frequently than many flexible rate advocates had expected, with the rates fluctuating widely in unanticipated directions and magnitudes, which consequently affected interest rate movements as the monetary authorities tried to influence exchange rates by movements in interest rates. The business world today has little doubt about the existence of currency risks and interest rate risks. With the persistent volatility of these factors, businesses, whether multinational corporations or domestic firms who are exposed to the impact of exchange rate changes through international competition, can be largely affected by these unanticipated movements and can cause very large gains or losses if the risks remain unmanaged. Exchange rates movements generate business risks of many types, often complex and sometimes hidden, which alter the value of existing foreign assets and liabilities, while movements in interest rates alter the value of a firm as it can indirectly affect the competitive position of the company which impacts the size of their future cash flows, also it alters the firms portfolio as interest rate movements influence the investment behaviour of firms through its effect on the cost of capital. Multinational corporations and domestic firms alike, who face these risks, must ensure that they manage these risks fully as the potential result of not managing currency risks and interest rate risks properly can be total failure of the business. With the sustained changes in the financial and competitive environment of most corporations, increased internalisation of economic activity and the

unprecedented era of world wide currency and interest rate volatility, new innovative foreign exchange risk and interest rate risk hedging techniques have grown at a rapid speed, and are designed to assist management in controlling risk and minimising the effect of uncertain cash flows. Financial institutions have provided companies with a range of products to assist in risk management. Table 1 shows the products and their year of introduction. The forward contract is the oldest instrument introduced to Table 1.0. Introduction of Derivatives Financial Derivative Instruments Year of introduction Foreign Exchange Instruments Forward Contracts on foreign exchange 1972 Foreign exchange futures 1972 Currency Swaps 1981 Options 1982 Interest Rate Instruments Futures contracts 1975 Interest rate swaps 1982 Interest rate options 1982 Interest rate forwards called forward rate agreements 1983 manage risks. It can be used to manage both interest rate and foreign exchange risks. A forward rate agreement is a forward contract on interest rates. A forward contract obligates its owner to buy a given asset on a specified date at a price specified at the origination of the contract. If the actual price at maturity is higher tan the specified price, the contract owner makes a profit and if the price is lower, the owner suffers a loss. A futures contract is similar to a forward contract in that it obligates its owner to buy a specified asset at a specified exercise price on the contract maturity date. The risk to the holder is unlimited, and because the payoff pattern is symmetrical, the risk

to the seller is unlimited as well. As with forward contracts, futures contracts can also be used to manage both foreign exchange risks and interest rate risks. Swap contracts can be considered as one of the latest financing innovations, after its public introduction in 1981, when IBM and the World Bank entered into a currency swap transaction 1 A swap contract obligates two parties to exchange specified cash flows at specified intervals. In general a swap contract can be defined as a series of forward contracts put together. A currency swap involves the exchange of interest rate payments in one currency for payments in another currency. Interest rate swap, which is the most common form of swap contracts, involves the exchange between two parties of interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time. An interest-rate swap is an agreement between two parties to exchange interest payments calculated on different bases over a period of time. In the most common form, one party makes fixedrate payments, while the other party's payments are based on a floating rate, such as LIBOR. Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Interest rate swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum. Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities (Chand Sooran). Compared to a forward, future or swap contract, an option contract gives the owner a right but not an obligation to buy (a call option) or to sell (a put option) an asset at a specified price

on or before a specified date. Upon exercise of the right, the option seller is obliged to deliver the specified asset at the specified price.

Managing Financial Risks with Derivatives: The case of the U.S Essay "Managing Financial Risks with Derivatives: The case of the U.S " from category Finance Name :Instructor s name :Course :Date :MANAGING FINANCIAL RISKS WITH DERIVATIVES : THE CASE OF THE U .S In this present world of prevailing dynamism monitory power operate as the supreme authority . It forms the lone means of fulfilling fundamental human requirements as well as aspirations . Thus economic instabilities like stock market crashes , fiscal depressions etc cast devastating effect on human life . Financial risk management is the process of creating economic value in an organization by the use of fiscal mechanisms to administer exposure to financial risks . Analogous to other forms of risk management , financial risk management calls for recognizing the cause of risk , measuring their intensity , and formulating strategies to address them . Financial risk management being a specialized form of risk management focuses on determining when and how to hedge , that is to make investments so as to reduce or cancel out the risk in another investment , using financial mechanisms to administer pricey exposures to risk .Aim and objectives Financial derivatives have brought about radical changes in the finance system by inventing new methods of understanding , measuring , and managing financial risks . In due course , derivatives make it possible for the organizations to shatter financial risks into smaller components and then to trade those components to achieve the best deal to meet specific risk-management objects . In addition ,

following a market-oriented attitude , derivatives make provisions for the free trading of individual risk components , in that way developing market efficiency . The use of financial derivatives must be considered as an essential part of any organization s riskmanagement policy to make sure that value-enhancing investment prospects can be achieved (Dev , 78-81 )The benefits of the use of financial derivatives are not limited to those organizations that use derivatives . The use of a growing variety of financial derivatives and the associated financial applications of more advanced approaches for determining and administering financial risks are the basic factors supporting the greater resilience of the largest financial organizations , which was so obvious for the duration of the credit cycle of 2001-02 and which still appears to have persisted . Derivatives have made the unbundling of financial risks possible . As the financial risks can be unbundled , now it is possible to analyze each and every financial instrument in terms of their common underlying risk factors , and risks can be better administered on a portfolio basis . To a certain extent because of the anticipated Basel II capital necessities , the complicated riskmanagement approaches that derivatives have made possible are being applied more widely and methodically in the banking and financial services industries .Conceivably the clearest substantiation of the professed benefits that derivatives have made possible is their sustained spectacular growth . As an outcome of the growing demand for these products , the dimension of the global OTC derivatives markets , according to the assessment of the Bank for International Settlements (BIS , attained a notional principal value of 220 trillion in June 2004 . Without a doubt , the growth rate of the OTC markets had become more rapid in 200104 than over the preceding three

Hedging & Derivative Risks Becomes Infinite Risk Options, Futures, other Derivatives, and Hedge funds are

Gambling Chips in a Worldwide Casino Japan Pays Back Wall Street Those crucial 170 words describing an honest, efficient, capitalist economy. Does anyone have the ear of President Barack Obamas Economic Recovery Team? The $700 trillion derivatives-hedge funds market is leveraged anywhere from 35 to 70 times. Citibank was leveraged at 280:1 The minimum risk of high leverage on a rising market becomes infinite risk as it unwinds rapidly. As soon as there is a major loss such as Bear Strearns was facing, those investors cannot pay up, hedge costs jump, and that bankrupts more derivative funds. As they are not paid, the intermediary bank cannot pay the winner of that bet so they go broke. The unpaid winners of those bets are on margin so they go broke. Just like Mafia betting, those who loaned the money for those bets go broke because nobody is able to pay them. Thus the Fed engineered the $30 billion plus rescue of Bear Stearns-JP Morgan to prevent a total meltdown of the then $526 trillion hedge fund-derivatives market which would have extinguished the entire banking structure operating those hedge funds off book. The little problem at Bear Stearns was just a little bump in the road. Eight months later Americas 20 largest banks were essentially bankrupt and being kept afloat by the Federal Reserve. The $2 trillion derivatives crisis at Citibank required that they be essentially nationalized. With close to $3 trillion pledged to throw at what could easily be a $10 trillion or even a $30 trillion problem, we have yet to see if money circulation increases or if investors running for the exits reduces the circulation of money (effectively destroying it) faster than money is thrown at the problem.

Options, Futures, other Derivatives, and Hedge funds are Gambling Chips in a Worldwide Casino The markets for stocks, bonds, commodities, futures, options, currencies, mortgages, money markets, in fact virtually every exchange market anywhere in the world, are now one huge market. Options, futures, swaps, forwards, other derivatives, all tools of hedge funds, are only the buyer betting that something will go up and the seller that it will go down; neither has a stake beyond the gamble. They appear to have a legitimate purpose in takeover schemes, but in that role, until a bubble tops out, they are not even gambles. The psychology of the market almost guarantees the stock price will rise when word gets out a takeover is in progress. This increase in valuation backs the money required for the takeover. The historic speculations in options, futures, and other simple bets are dwarfed by the derivative markets of the late 20th to early 21st century which evolved to bypass the markets margin limitations. Long-Term Capital Managements bankruptcy crisis in 1998 uncovered the unsettling reality that this small hedge fund with a capital base of only $2 billion had over $1 trillion in bets in the derivatives markets, betting primarily on the Russian Ruble whose value had been successfully destroyed. This was a margin of only 0.02% and many of the estimated 400 other hedge funds then operating would have had similar slim margins bet on similarly volatile currencies. By late 2007, derivatives bets by the then 10,000 hedge funds created a $416 trillion house of cards, eight times the GDP of the world economy, which climbed to $526 trillion even as 20 of Americas largest banks were facing insolvency and the world

economy was shrinking. The $200 billion written off by the banking system in February 2008, means roughly a $2 trillion shrinkage in circulating money (circulation of base money is the money supply). So a financial bubble dependent upon continued expansion can unwind very fast and these same banks are now considered to have at least $800 billion more in bad paper to write down. For that to happen would mean a $20 trillion shrinkage in circulating money (the money supply) which would be a total collapse of the economy. Thus it is obvious why the Federal Reserve/Treasury is desperately pouring money at those banks and other sectors of the economy. To avoid throwing the worlds financial markets into turmoil bankrupt hundreds of hedge funds wipe out big-name financial institutions sabotage the investments of pension funds and scramble the portfolios of millions of average investors, the worlds central banks are pushing huge sums of created money at the financial markets. The world holds their breath as to whether they collectively can keep markets from gridlocking (Google the above quoted phrases). All aspects of the markets have become chips in a casino game, played for high stakes by people who produce nothing, invent nothing, grow nothing and service nothing. The evening news alerted us that one-third of the cost of oil was due to the speculative buying of oil contracts. That, and the same trading practices in other markets, is another form of harvesting unearned profits. Sharp traders have leveraged world markets with stock and

currency options, futures on options, meaning options on options, futures on interest rates, warrants, a form of option, and thousands of other similar subdivisions of instruments, called derivatives, designed to lay claim to wealth properly belonging to your, me, and all other productive citizens. Hedge funds betting on which way everything in the markets, and sometimes outside the market (weather for example) will go, leveraging those bets up to 70 times (meaning betting with borrowed money) and, as said above, doing all this to the tune of $526 trillion worth of derivative bets is what has all markets of the world holding their breath. The collapse of the huge housing bubble in America triggered the crisis but was not the cause. Interest rates were kept low, borrowers with poor credit or no credit were loaned money on houses that were rapidly appreciating in value due to those lax standards. Speculators were borrowing against their homes to buy more expensive homes and condominiums which were rising 10 to 20% a year in price. Most of those speculators started out with good credit. But when the rise in home prices topped out and the bubble burst they were stuck with paying mortgages on homes priced higher than their mortgage. Those who could not afford to pay for their newly-purchased homes and those who will drop into the insolvent class due to the value collapse of their speculations may eventually be four million, far more if this collapses into a depression. Those subprime loans were sold to Fannie Mae and Freddie Mac, the primary financing for home loans, and others. The two FMs, banks, and other traders packaged those subprime loans in with prime loans, gave them a triple A rating, and sold those bundled

debt instruments, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs), etc, on the markets. Those toxic debt instruments functioning as bonds were bought by investors worldwide. Problems arose when word leaked out that many of the debts within those bonds were uncollectable. Quickly the markets seized up. The forced revaluations became the first $200 billion dollar write down of major banks addressed above. Central bank funds pouring $2 trillion to $3 trillion at the ethereal world of high finance instead of at the real economy indirectly includes those hedge funds. If these publicly provided trillions of dollars do not turn the financial markets around, those central banks will have to loan directly to the real economy, a right that, in an emergency, the U.S. Federal Reserve has always had. If investor and consumer confidence collapse, those funds distributed, not loaned, directly to consumersas outlined in The simplicity of eliminating poverty and war will stun youmay be required to restart the economies. On a very small scale, $165 billion, has already been distributed directly to the consumers. With a sharp drop in the service sector indexes, an ethereal world of high finance leveraged from 35:1 to 70:1 can unwind very fast. A short summary: Far more wealth is appropriated from the citizenry than is necessary to operate the economy. Even then after honest investmentextravagant living, waste within the economy, and wars to protect it all, there are, in the expanding phase of a cycle, still massive investment funds left over.

Inevitably the inscrutable games within the ethereal world of high finance are created so as to have a place to invest. But these self delusions collapse when reality bursts that bubble which is where the world is at today. As outlined on pages 38-50, 119-20, 143-51 of Economic Democracy: A Grand Strategy for World Peace and Prosperity, and in the conclusion of Money: A Mirror Image of the Economy demonstrating that 40% of todays finance capital can operate the economy at double the efficiencysuch strategies to lay claim to others wealth can never evolve in a fully transparent economy with full and equal rights. Hedging Instrument Definition: A hedging instrument is a designated financial instrument whose fair value or related cash flows should offset changes in the fair value or cash flows of a designated hedged item. A hedged item is an asset, liability, commitment, highly probable transaction, or investment in a foreign operation that exposes an entity to changes in fair value or cash flows, and is designated as being hedged. Examples of Derivatives Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual delivery of the item specified in the contract, or by a net cash settlement. Futures: Contracts similar to forwards but with the following differences: futures are generic exchange-traded, whereas forwards are individually tailored. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash

settlement. Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. These can be individually written or exchangetraded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option.