Derivative Market
Financial markets are classified in terms of cash market and derivative markets. The cash market, also referred to as the spot market, is the market for the immediate purchase and sale of a financial instrument. In contrast, some financial instruments are contracts that specify that the contract holder has either the obligation or the choice to buy or sell another something at or by some future date. The “something” that is the subject of the contract is called the underlying. The underlying is a stock, a bond, a financial index, an interest rate, a currency, or a commodity. Because the price of such contracts derive their value from the value of the underlying, these contracts are called derivative instruments and the market where they are traded is called the derivatives market.
Derivatives instruments, or simply derivatives, include futures, forwards, options, swaps, caps, and floors. We postpone a discussion of these important financial instruments until Chapter 6 and their applications in corporate finance and portfolio management to later chapters.
The primary role of derivative instruments is to provide a transactionally efficient vehicle for protecting against various types of risk encountered by investors and issuers. In the absence of derivative instruments and the markets in which they trade, the global financial system throughout the world would not be as efficient or integrated as they are today. A May 1994 report published by the U.S. General Accounting Office (GAO) titled Financial Derivatives: Actions Needed to Protect the Financial System recognized the importance of derivatives for market participants. Page 6 of the report states:
Derivatives serve an important function of the global financial marketplace, providing end-users with opportunities to better manage financial risks associated with their business transactions. The rapid growth and increasing complexity of derivatives reflect both the increased demand from end-users for better ways to manage their financial risks and the innovative capacity of the financial services industry to respond to market demands.
On February 10, 2000, in testimony before the U.S. Senate Committee on Agriculture, Nutrition, and Forestry, Alan Greenspan, then chairman of the Federal Reserve, stated that “Over-the-counter (OTC) derivatives have come to play an exceptionally important role in our financial system and in our economy. These instruments allow users to unbundle risks and allocate them to the investors most willing and able to assume them.”
Admittedly, it is difficult to see at this early stage how derivatives are useful for controlling risk in an efficient way since too often the popular press focuses on how derivatives have misused by corporate treasurers or portfolio managers.
Derivative Market
Financial markets are classified in terms of cash market and derivative markets. The cash market, also referred to as the spot market, is the market for the immediate purchase and sale of a financial instrument. In contrast, some financial instruments are contracts that specify that the contract holder has either the obligation or the choice to buy or sell another something at or by some future date. The “something” that is the subject of the contract is called the underlying. The underlying is a stock, a bond, a financial index, an interest rate, a currency, or a commodity. Because the price of such contracts derive their value from the value of the underlying, these contracts are called derivative instruments and the market where they are traded is called the derivatives market.
Derivatives instruments, or simply derivatives, include futures, forwards, options, swaps, caps, and floors. We postpone a discussion of these important financial instruments until Chapter 6 and their applications in corporate finance and portfolio management to later chapters.
The primary role of derivative instruments is to provide a transactionally efficient vehicle for protecting against various types of risk encountered by investors and issuers. In the absence of derivative instruments and the markets in which they trade, the global financial system throughout the world would not be as efficient or integrated as they are today. A May 1994 report published by the U.S. General Accounting Office (GAO) titled Financial Derivatives: Actions Needed to Protect the Financial System recognized the importance of derivatives for market participants. Page 6 of the report states:
Derivatives serve an important function of the global financial marketplace, providing end-users with opportunities to better manage financial risks associated with their business transactions. The rapid growth and increasing complexity of derivatives reflect both the increased demand from end-users for better ways to manage their financial risks and the innovative capacity of the financial services industry to respond to market demands.
On February 10, 2000, in testimony before the U.S. Senate Committee on Agriculture, Nutrition, and Forestry, Alan Greenspan, then chairman of the Federal Reserve, stated that “Over-the-counter (OTC) derivatives have come to play an exceptionally important role in our financial system and in our economy. These instruments allow users to unbundle risks and allocate them to the investors most willing and able to assume them.”
Admittedly, it is difficult to see at this early stage how derivatives are useful for controlling risk in an efficient way since too often the popular press focuses on how derivatives have misused by corporate treasurers or portfolio managers.