Financial Management

Posted: October 17th, 2013

Financial Management

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Financial Management

Derivative security is a financial instrument that derives its value from another security. It is also defined as a financial instrument whose price is dependent on one or more underlying financial assets (Back, 2005). The derivative itself is usually an agreement between two parties to contract at a certain date, with a certain value. It is usually an agreement to sell or buy assets at a pre-determined fixed price before a certain date expires. The price of the derivative security will be determined by underlying assets such as stock, commodities, currency, bond interest rates and market indexes. In most cases, it is used by investors interested in hedging or offsetting the risks involved in investments (Back, 2005). Commonly traded derivatives are such as future contracts, which allow transferring of an asset in the future, at a price agreed in the current. Option is another derivative security that gives one the right to buy or sell an asset in a predetermined date at a specified price. Another derivative is the Swaps, allowing exchange of cash flows with another set of cash flows (Poitras, 2002).

Derivative securities play very important roles to various parties as well as markets. Among the importance is allowing transfer of wealth among people without much risk associated with the dynamic market (Poitras, 2002). Another importance of derivative markets is improving efficiency in the capital markets, which are crucial for the output as well as growth of the economy. Firms require capital in order to continue with their production and maintaining of their labor forces. This capital comes from the people or investors who sell or buy securities from firms directly or through financial institutions. Therefore, when the capital markets are not efficient, they hinder efficiency of firms, thus development of the economy goes down (homepages.rpi.edu, 2012).

References

Back, K. (2005). A Course in Derivative Securities: Introduction to Theory and Computation. New York, N.Y: Springer.

homepages.rpi.edu. (2012). Chapter 9: Derivative Securities and Risk Management. Retrieved from http://homepages.rpi.edu/~tealj2/corp09.pdf

Poitras, G. (2002). Risk Management, Speculation, and Derivative Securities. San Diego, CA: Academic Press.