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Derivative Securities Research Paper

3983 words - 16 pages

Derivative securities are a result of financial innovation and their value is dependent upon the value of an underlying security. They are also called contingent claims since their value is contingent upon the value of another security. The most important use of derivatives is risk-reduction, called hedging. Derivatives "hedging," is based on the idea that the change in the value of a derivatives position can offset the change in the value of the underlying asset .The derivatives market has developed in response to the uncertainty of prices, and therefore has provided a means of controlling this price volatility. The tendency of the market to move up or down in what appears to be a random ...view middle of the document...

S. Treasury securities.Options are possibly the most popular and recognized derivatives and they exist on countless underlying securities. Options give the buyer the right, but not the obligation, to buy or sell an option at a pre-specified price, depending on whether the option is a call or a put. The pre-specified price is called the strike price at which the stock can be bought (call option) or sold (put option). This can be illustrated using the example of Intel's stock. A call option to buy Intel's stock can be bought that would allow the investor (owner) to exercise at or before the expiration date if the price of the stock increases to a level greater than the strike price. Similarly, a put option lets the investor sell the stock if the price of the stock falls below the strike price and make a profit.Forwards and Futures ContractsForwards contracts represent the obligation to buy or sell a security at a pre-specified price at a future date. For example, a forward contract for ten thousand bushels of corn might be bought by a farmer who predicts that the price of corn will decrease in the future enabling the farmer to benefit from the transaction, provided that there is an investor willing to complete the deal by providing the corn and agreeing on the future price. Forwards contracts cost nothing to enter into and are therefore, inexpensive but difficult to enter into since they are not administered by an exchange and also because it is difficult to find an investor willing to enter into a forward contract and agreeing to the forward price and expiration date.Futures contracts are basically forwards contracts that are traded on organized exchanges where trades are administered by a clearinghouse. The clearinghouse charges a fee per transaction. With a futures contract, investors benefit from the flexibility offered since they are not obligated to pay or receive the future price as required by the contract. They can buy or sell at any time before expiration and void the contract if there is a prospect of a profitable opportunity that is more lucrative than the one offered at the date of expiration. For example, if a Multinational Corporation would like to enter into a futures contract to buy one hundred million Euros one month from now because they expect the price of Euros to decrease in the future, they can do that through the Chicago Mercantile Exchange by entering into a futures contract. They will be required to pay to the clearinghouse a transactions cost, which is usually a small percentage of the actual transaction amount, to enter into the futures contract for this foreign exchange transaction. Once a contract is established and an expiration date fixed, the firm can either wait until the expiration date to cash out or it can cash out at any time before the expiration date if it feels there is a lucrative opportunity at hand which would provide a better return than the one earned at end of the contract. The firm pays the...

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