What are the specific
roles
and
functions
of derivatives in financial markets and in the real economy?
-
role derivatives have played in the emergence and severity of the financial crisis of 2007-2008.
-
Comment upon how the existence of derivatives markets enhances an economy’s ability to grow.
Derivatives can be defined as financial products, such as futures contracts, options andmortgage backed securities. Most of derivatives value is based on the value of an underlyingsecurity, commodity, or other financial statement
. More simply, derivatives in finance have asimilar basic principle as the field of Chemistry in which a derivative is defined as ‘asubstance that can be derived from another substance.’
Essentially, the purpose and initialfunction of Derivatives is to promote economic efficiency by hedging financial risk orspeculation, as well as playing a role in helping minimize information asymmetry betweendepositors and administration. If this is the role they play, at first glance it is difficult to seehow they are implicated in the 2007 – 2008 financial crisis. The idea and thinking behind the working of derivatives can be traced back to evenAristotelian times
and is seen throughout history such as in the
letter de faire,
a form of future contract used in trading contracts in the 12
th
Century
. However it was not really until1975 when the Chicago Board of Trade recognised that by turning future contacts intofinancial instruments, i.e. financial derivatives, risk could be hedged, that financialderivatives came into mainstream use. They seemed to be the instrument that would cure many problems, enabling people toformulate plans with greater confidence about the costs of their finance. Financial derivativescome in a variety of different formats; options, giving one the option to buy or sell somethingin the future at a fixed price, swaps, contracts allowing one to swap one cash flow for anotherand Future and forward contracts. They can also be divided into two categories, ‘EquityDerivatives’ and ‘Credit Derivatives’, the latter being the most common. Credit Derivativesgive the user exposure to credit risk; the price is guided by the credit risk of the economicagents such as private investors or governments.Derivatives are used extensively in the financial markets and real economy because they dohold a substantial amount of benefits. They allow both firms and individuals to achievepayoffs which would not be achievable otherwise as well as enabling investors to tradeinformation which would otherwise be unaffordable. This increases efficiency with in thefinancial markets. Without financial derivatives one would have to sell a stock which one doesnot own, often a challenging task, as such stock must be borrowed from he who does own
1
Morris, Virgi
nia B:
Standard & Poor’s Dictionary of Finan
cial Terms
(Lightbulb Press, Inc., 2007) pg. 55
2
Merriam Webster in
c.:
The Merr
iam Web
ster Dict
ionary
(Merriam Webster, 1997)
3
Siems, T. F.:
10 Myths about Financial Derivatives,
(Cato Policy Analysis no. 283 – 199
7).
4
Capasso, D. R.:
Trading on the Seattle Merc,
(New York, J. Wiley. - 1995)
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