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Essay on Financial Instruments: Classification of Derivatives

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Introduction:
Definition:
A derivative is a financial instrument whose value is derived from the value of another asset, which is known as underlying.
• If the price of the underlying assets changes then the value of the derivatives also changes.
• Basically a derivative is not a product. It is a contract which derives its value from the changes in the price of those underlying assets.

Example: The value of a gold futures contract is derived from the value of the underlying asset i.e. gold.

Classification of Derivatives: Derivatives are classified in terms of their payoffs and as exchange traded and over the counters.
• Linear Derivatives: Linear Derivatives have linear payoff. E.g. Futures and forwards.
• Non Linear Derivatives: Non Linear Derivatives have non linear payoffs. E.g. Options.
• Exchange traded: These are standardized instruments and are backed by clearing house. So there is no default risk. E.g. Futures.
• Over the counters: Over the counters are customized contracts and they bare default risk. E.g. Swaps and Forwards.
Histroy:
The history of derivatives is quite colorful and surprisingly a lot longer than most people think. Derivatives were first instruments developed to secure the supply of commodities and facilitate trade as well as to insure farmers against crop failures. The history of derivatives provides evidence that the first derivatives markets were over the counter (OTC).
In the 1980s
In Ancient Mesopotamia trade were encouraging and supply of commodities were securing and required that sales, purchases and other commercial agreements must be in written fo...


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...h. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counter-parties to avoid trading with or lending to the institution.
Market Risk: Fluctuation in the prices of the underlying asset contributes to market risk. Market risk comprises of four risk factors: Equity risk, Interest rate risk, Currency risk and Commodity risk. In general risk varies from sector to sector.
For example Banks use derivatives to hedge against risks that may affect their operations and earnings including interest rate risk, market risk, foreign exchange risk and counter-party risk.
Farmers use derivatives to lock the price of their crops in order to protect their harvest, so they are exposed to price risk.
The importance of derivatives is increasing day by days because of high volatility in the market.






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