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Capital market and derivatives 1

CAPITAL MARKET AND DERIVATIVES

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Capital market and derivatives 2 Table of contents Introduction……………………………………………………………………………………3 The capital market…………………………………………………………………………..Student’s ID.…3 Derivatives……………………………………………………………………………………..13 Course.7 Risks……………………………………………………………………………………………9 Conclusion……………………………………………………………………………………12 Reference List……………………………………………………………………………….. year of study....5 Benefits………………………………………………………………………………………. module .

and the price of unawareness in derivatives is quite high. Capital market and derivatives 3 Introduction The main driving force of the progress. which is essential for development. Thus. where the object of the agreement is a money capital granted as a loan and where supply and demand are formed on it. year of study. in foreign currency and so on. including the mechanisms of the market economy. in real estate. cash income. this paper explores the peculiarities of capital market and derivatives as a port of it. 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.Student’s ID. some working capital in cash. But one of the most popular ways of investing in modern developed capital markets. The form of loan capital’s movement is a credit. The development of the capital market is also subject to the general rule. The funds can be invested in many known ways: in the share capital. 2009). income that goes for restoring and expanding production. is the use of derivative for this purpose. Its main source is funds released in the process of reproduction (the depreciation funds of companies. in gold. module . pursuing not only the aim of making a profit but also insuring the capital. in bonds and other securities. Course. It is a specific sphere of market relations. It is necessary to introduce the derivatives in domestic circulations wider. and savings of the general population). The benefits that can be got from this are countless. 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. and the innovations among financial instruments are derivative financial instruments or derivatives. is innovation. On the capital market loans are granted for more than one year (Fabozzi and Drake.

It is also a major source of long-term investment resources for the government. From a functional point of view. the capital movements within the country. The main participants of this market are primary investors (the owners of free financial resources mobilized by banks and converted into loan capital). the transformation of money savings into capital investments. Thus. From the institutional point of view. thus. corporations. and banks. to a wide development of the loan capital market in the total market. largely to meet short-term needs. 2009). in the high level of the money capital’s accumulation. Capital market and derivatives 4 The capital market contributes to an increase in production and commodity circulation. module . the capital market is a system of market relations. that is divided into the stock market and the medium and long-term bank loans market. in the form of circulation of usurers’ capital. as well as the functioning of credit auctions (Fabozzi and Drake. the turnover of commercial and banking credits. The economic role of the market is in its ability to combine small and scattered money. The most developed capital market is considered the US market. ensuring the accumulation and redistribution of money capital in order to ensure the reproduction process. and. the capital market is an integral part of the financial market. It is distinguishable in branching.Student’s ID. actively influence the concentration and centralization of production and capital. it is a set of financial institutions and stock exchanges. as well as in the broad internationalization (Fabozzi and Drake. and the resumption of the main capital. The capital market evolved from the origin on the market of simple commodity production. the capital market provides long-term needs in financial resources. the presence of powerful credit system and developed securities market. through which a loan capital moves (Fabozzi and Drake. When a money market provides highly liquid funds. year of study. specialized Course. 2009). 2009). It covers the turnover of loan and banking capital.

2014). swaps on interest rates and currencies. derivatives market. transformation and reducing risks. containing a relation. 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. 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. the derivatives appeared the global market of which is now the most dynamic segment of the global capital market (Hodkins. many experts call the instability of international financial markets in the 1970s.Student’s ID. 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. module . currencies. The capital market’s structure can be represented as the sum of the currency market. As a result. 2009). year of study. and the obligations concerning the securities themselves . credit market and the stock market (Fabozzi and Drake. insurance market. prices of which are linked to other financial or real assets.derivatives. 2014). securities. Course. as well as forward contracts (Hodkins. and its further temporary transferring to lenders on repayment basis for a fee in the form of interest). the converting of them into the loan capital. Under the financial derivatives understand the financial risk trade instruments. The prerequisites for the development of the derivatives market. interest rates and stock indices. causing an acute need in the development of the financial instruments. Capital market and derivatives 5 intermediaries (credit and financial organizations that carry out the direct involvement (accumulation) of funds. The main derivatives include futures and options on commodities. 2009).

2014). in transactions participate management companies and corporations. Capital market and derivatives 6 When buying and selling derivatives. arising from these assets. It is due to the high volatility of quotations and increasing of the losses risk in the face of declining rates. The derivative’s objective is the fixation of future price of any asset already today. price indices or by the differences between the two prices. 2014).Student’s ID. currency futures and options. futures and options on indexes) and derivatives sold outside the stock exchange (currency and percentage instruments) (Hodkins. year of study. The international derivatives trade is conducted on stock exchanges and OTC. The international derivatives market is characterized by the increasing volume of transactions with derivative instruments. 2014). Herewith. the counterparties share risks. In addition to institutional investors. module . the derivatives market replenished with new members. the exchange of cash flows or the exchange of assets (swaps). 2014). to conduct the transaction (Hodkins. Course. The turnover of derivatives market eight times exceeds the global GDP. the change of ownership or putting a definite product is not expected (Hodkins. financial instruments prices. reached by concluding a forward or futures contract. instead of assets. 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. According to the Bank for International Settlements. the total volume of an international derivatives market is near 300 trillion dollars (Hodkins. Recently. Derivatives contracts are closed by cash. and the acquisition of right. The price of the derivative is defined by the movement in commodity prices. but not the obligation. It has led to the separation of these financial instruments on derivatives sold on stock exchanges (percentage futures and options.

year of study. the market volume in absolute terms has increased 133 times. to implement the transfer of price risks (Madhumathi and Ranganatham. the share of the OTC market increased from 60% to 90%. followed by a fairly close in volumes European (38. Financial derivatives are very diverse in their characteristics – liquidity. a further stabilization and a gradual increase to 70% of pre-crisis turnover in 2013.Student’s ID. Capital market and derivatives 7 The volume of the OTC transactions on the international derivatives market significantly exceeds the volume of stock exchanges’ transactions. the main benefit of derivatives is hedging risks. Thus. 2012).200. During that time. At the same time. availability. 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. OTC . In general.71%). The world's largest derivatives market is a North American (54%). term agreements enable the division into components those risks that are inherent in the basic instruments. 2014). the global OTC derivatives market almost did not respond to the crisis of 2008 (Hodkins. module . cost. 2014). The volume of stock exchange market grew approximately 30 times. After the global financial crisis in 2008. and risk. and simultaneously enable redistribution of them among the participants of an agreement. Course. each instrument has its advantages and disadvantages (Hodkins. It provides the possibility to trade risk separately from the basic instruments. scilicet. 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. on the stock exchange market is observed a significant decline in trade. Therefore. and in the recent decades.

Moreover.Student’s ID. it's a free shoulder. As a result of falling oil prices in the mid-eighties. and when the oil price grew. module .5 billion. 2012). It hedges approximately half of the volume of an aviation fuel consumed through futures contracts in Singapore. in relation to the real value of certain assets and the future direction of the economy development (Madhumathi and Ranganatham. Drawing the appropriate conclusions. Secondly. Capital market and derivatives 8 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. These operations allowed the airline to save 140 million Singapore dollars in the last fiscal year and 66 million the year before. Hedge was drafted in such a way that the minimum price of oil was fixed at $ 21. was provided the additional income to the Treasury (Scherer and Winston. year of study. playing on the decrease does not require additional expenses as on the Course. derivatives are means of insurance from which not only insurance companies can earn but virtually anyone.5 per barrel. Additionally. reaching a 1:50 ratio at many marketplaces. financial derivatives allow earning both on the increase and decrease in the value of the instrument. insure tax revenues from the oil companies. the benefits of derivatives over shares or other underlying assets are plentiful. And this provides the information to individuals who are monitoring the market. 2012). Moreover. the positive effect from the hedging has a Singapore Airlines Ltd. the airlines of the developed countries hedge 30-60% of fuel consumed (Fedorovoa. In this state. in order to avoid a similar situation in the future. concluding agreements with financial derivatives leads to the establishment of the prices that can observe and evaluate all society. In fact. The share of such contributions is about a quarter of the state treasury. Besides. Firstly. today. experts have developed a program of tax revenue hedging using options on the New York Stock Exchange NYMEX. Also. the state budget has missed of $ 3. 2004).

module . Thus. thus. 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.e. In futures stock exchanges. Risks With the emergence of forms of exchange trade. The main advantage of using credit derivatives is the opportunity to create more efficient banking portfolios. using derivatives. 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).Student’s ID. when the bank for whatever reasons (e. year of study.. the derivatives created favorable conditions for speculative operations. it can serve as an instrument to attract additional investments in the project. Therefore. 2012). it requires a dynamic trade (i. One of the most popular and successfully used types of derivative financial instruments are credit derivatives. Third. Such approach can significantly expand the number of Course. 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. 2009).. In addition to market risk management. because of the threat of default or regulatory authorities restrictions) is temporarily unable to purchase the asset (Madhumathi and Ranganatham.g. the derivatives make market being full (add a new payment structure that cannot be reproduced with the help of existing assets) and. 2012). add new capabilities to the financial system (Bouchaud and Potters. Capital market and derivatives 9 stock market. it is necessary to review the structure of the portfolio when market conditions change). it is possible to make a profit even from stagnation on the stock market. 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. Finally.

the interest rates grew rising borrowing costs and lowering the long positions’ price. Capital market and derivatives 10 participants. 2014). It is clear that forecasts are not always translated into reality. which can be not only legal entities (banks. such as credit. insurance companies. After the state of California reduced funding of counties. and. Totally. As an example of risks associated with derivatives and failing speculation can be Orange County. therefore. allowing stock speculators guarantee their forecasts and carrying out speculative operations to obtain profit from price differences (Madhumathi and Ranganatham. year of study. speculating that the interest rate would stay the same or even lower. The credit risk is one of the main risks inherent in financial derivatives. The derivatives are subject to certain risks. It invested in many derivatives. allowing concluding agreements in large volumes at any time. The organization of stock exchange trading forms strongly simplifies the speculative operations. speculators lose over 75% of the money on the foreign exchanges as a result of transactions with derivatives (Madhumathi and Ranganatham. the Orange County became a bankrupt being incapable to fulfil its obligations. but using the derivatives incorrectly can multiplex them repeatedly. module . speculators can also lose what happens frequently in practice. investment funds. corporations. it began to purchase fixed income in the long position. and from another side. 2012).7 billion from such speculation (Hodkins. 2012). By some estimates. 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. In the terminal market.Student’s ID. After that. it lost near $1. Besides the Course. market and legal. the Orange County became strongly depended on investments in order to obtain revenue. pension funds) but also individuals. In short time. These types of risks are not new. Ultimately.

Student’s ID. theoretically. are excessive instruments (Bouchaud and Potters. are redundant instruments. do not bring the financial system anything new. therefore. In practice. For example. the probability of a simultaneous default on both transactions is extremely low. The history and reputation of the counterparty may be uncertain. may be considered as a credit event (Madhumathi and Ranganatham. and the unprescribed conditions of debt restructuring of the credit protection seller to the buyer in case of a credit event (Madhumathi and Ranganatham. In this case. the buyer of protection bears a double loss. 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. Capital market and derivatives 11 probability of default of the underlying asset. 2009). 2012). This factor relates to the market and to the legal risk. Additionally. but it cannot be ignored. To the legal risks are directly related such factors as incomplete or insufficiently clear definition of the terms of the deal. and. Course. the probability of a simultaneous default increases significantly. year of study. when the underlying asset and the seller of protection are in the same area or are related to the same industry. thus. etc) (Madhumathi and Ranganatham. Thus. and. from the economic point of view. disregard for likelihood of a merger or acquisition of a credit protection seller with the occurrence of difficulties in the implementation of previous agreements. can also default a seller of protection. in some cases. The Derivative pricing theory suggests that derivatives. 2012). The market risk is speculative. derivatives can be reproduced by building a portfolio of existing assets. and. 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). module . decline in general regional or sectoral quotations of securities. 2012). Special attention deserves the legal risk.

In this sense. the main of which is the transformation of the financial risk considering the specified parameters of management strategy. At the same time. Capital market and derivatives 12 Conclusion In conclusion. Although at transactions with derivative financial instruments arise risks of standard varieties. their practical manifestation can take new forms. year of study.Student’s ID. and innovative resources of the financial sector that is able to respond quickly to the dynamic changes in that demand. the use of derivatives provides for economic operators numerous advantages. 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. Word count: 2890 Course. 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. module .

Cambridge. viewed 17 February 2016. New York. The Oxford Handbook of Quantitative Asset Management. Course. Inc. Finance: Capital Markets. year of study.. B 2012. and Investment Management. JF & Drake. Usage of Derivatives in Business Today. 2nd edn.edu/cgi/viewcontent. New Dehli.. Oxford University Press. Fedorovoa. <http://digitalcommons. Inc. Scherer. TA 2004. viewed 17 February 2016.biz/about-insurance/airline-indemnity-against-59545.html> Hodgkins. Dorling Kindersley Pvt. module .. Inc. JD 2014.uconn. Derivatives and Risk Management. Honors Scholar Theses. PP 2009. Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management. Financial Management. J & Potters. Cambridge University Press. Capital market and derivatives 13 Reference List Bouchaud. M 2009. R & Ranganatham. <http://the-books.cgi? article=1348&context=srhonors_theses> Madhumathi. Airline Indemnity Against Liability. Fabozzi. John Wiley & Sons. New Jersey.Student’s ID. M 2012.