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Capital Market and Derivatives

Free Business Essays

The Capital Market

Innovation is a driving force of the development. In the capital market, such innovations are derivatives. Every day they become more and more popular. Derivatives help not only to make profit but also to insure business. However, in spite of many benefits, there are also risks associated with derivatives.

The capital market increases the production and commodity circulation, promotes capital movements, transformation of money savings into capital investments, and resumption of the main capital. It consists of the currency market, derivatives market, insurance market, credit market, and the stock market. The derivative financial instruments appeared due to the instability of the financial market in the 1970s. It is a document that certifies the right or the obligation to buy or sell the underlying asset at specified conditions in the future. The derivatives trade occurs on the stock exchanges and OTC. The OTC market is bigger and more stable. Derivatives have many benefits, the most important of which is the ability to hedge risks. The great examples of hedging risks with the help of derivatives is the actions of the state of Taxes that developed a program of tax revenue hedging using options on the New York Stock Exchange NYMEX, as well as Singapore Airlines Ltd that hedges near half of the volume of the aviation fuel consumed through futures contracts. Moreover, basing on the derivative pricing theory, derivatives make market being full and, thus, add new capabilities to the financial system. However, derivatives create favourable conditions for speculative operations. Speculators’ forecasts are not always correct, and they frequently lose money. A great example is the Orange County that invested in derivatives, speculating that the interest rate would not rise but later became a bankrupt. Thus, managers and financial institutions should be well aware of derivatives’ potential risks and know how to use them efficiently.

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The main driving force of the progress, which is essential for development, including the mechanisms of the market economy, is innovation. The development of the capital market is also subject to the general rule, and innovations among financial instruments are derivative financial instruments or derivatives. It is necessary to introduce derivatives in local circulations wider. A person can invest funds in many known ways: in the share capital, in bonds and other securities, in real estate, in gold, in foreign currency and so on. However, one of the most popular ways of investing in modern developed capital markets, pursuing not only the aim of making a profit but also insuring the capital, is the use of derivative for this purpose. The benefits from this option are countless, and the price of unawareness in derivatives is quite high. Thus, this paper explores the peculiarities of the capital market and derivatives as a part of it, as well as analyses the benefits and risks associated with the usage of derivatives to make a better understanding of them and how correctly use them.

The capital market is a type of financial market where supply and demand are formed mainly in the medium-term and long-term loan capital. It is a specific sphere of market relations, where the object of the agreement is a money capital, granted as a loan and where supply and demand are formed on it. The form of loan capital’s movement is a credit. Its main source is funds released in the process of reproduction (the depreciation funds of companies, some working capital in cash, income that goes for restoring and expanding production, cash income, and savings of general population). On the capital market, loans are granted for more than one year (Fabozzi & Drake 2009).

The capital market contributes to an increase in production and commodity circulation, capital movements within the country, money savings transformation into capital investments, and resumption of the main capital. The economic role of the market is in its ability to combine small and scattered money, and, thus, actively influence the concentration and centralization of production and capital. From a functional point of view, the capital market is a system of market relations, ensuring accumulation and redistribution of money capital in order to ensure the reproduction process. From the institutional point of view, it is a set of financial institutions and stock exchanges, through which a loan capital moves (Fabozzi & Drake 2009).

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Thus, the capital market is an integral part of the financial market, that is divided into the stock market and the medium and long-term bank loans market. It is also a major source of long-term investment resources for the government, corporations, and banks. When the money market provides highly liquid funds, largely to meet short-term needs, the capital market provides long-term needs in financial resources. It covers the turnover of loan and banking capital, the turnover of commercial and banking credits, as well as the functioning of credit auctions (Fabozzi & Drake 2009).

The capital market evolved from the origin on the market of simple commodity production, in the form of circulation of usurers’ capital, to a wide development of the loan capital market in the total market. The most developed capital market is the US market. It is distinguishable in branching, the presence of powerful credit system and developed securities market, in the high level of the money capital’s accumulation, as well as in the broad internationalization (Fabozzi & Drake 2009).

The main participants of this market are primary investors (owners of free financial resources mobilized by banks and converted into loan capital), specialized intermediaries (credit and financial organizations that carry out the direct involvement (accumulation) of funds, the converting of them into the loan capital, and its further temporary transferring to lenders on repayment basis for a fee in the form of interest), 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 & Drake 2009).

The capital market’s structure can be represented as the sum of the currency market, derivatives market, insurance market, credit market, and the stock market (Fabozzi & Drake 2009).

Derivatives

The peculiarity of the global capital markets’ development in the last third of the 20th century was the emergence of a variety of rights not based on a real asset, containing a relation, and the obligations concerning the securities themselves – derivatives. Many experts call the instability of international financial markets in the 1970s as the prerequisites for the development of the derivatives market, causing an acute need in the development of financial instruments, transformation and reducing risks. As a result, derivatives appeared on the global market of which is now the most dynamic segment of the global capital market (Hodgkins 2014).

Financial derivatives are the financial risk trade instruments, prices of which are linked to other financial or real assets. A derivative is a standard document that certifies the right and (or) obligation to buy or sell the underlying asset at specified conditions in the future. The main derivatives include futures and options on commodities, securities, currencies, interest rates, and stock indices, swaps on interest rates and currencies, as well as forward contracts (Hodgkins 2014).

When buying or selling derivatives, the counterparties share risks, instead of assets, arising from these assets. The price of the derivative is defined by the movement in commodity prices, financial instruments prices, price indices or by the differences between the two prices. Derivatives contracts are closed by cash. Herewith, the change of ownership or putting a definite product is not expected (Hodgkins 2014).

The derivative’s objective is the fixation of future price of any asset today, reached by concluding a forward or a futures contract, the exchange of cash flows or the exchange of assets (swaps), as well as the acquisition of right, but not the obligation to conduct the transaction (Hodgkins 2014).

The international derivatives market is characterized by the increasing volume of transactions with derivative instruments. It is due to the high volatility of quotations and increasing of the losses risk in the face of declining rates. Recently, the derivatives market replenished with new members. In addition to institutional investors, management companies and corporations participate in transactions. 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. The turnover of derivatives market eight times exceeds the global GDP. According to the Bank for International Settlements, the total volume of international derivatives market is near $300 trillion (Hodgkins 2014).

The international derivatives trade is conducted on stock exchanges and OTC. It has led to the separation of these financial instruments on derivatives sold on stock exchanges (percentage futures and options, currency futures and options, futures and options on indexes) and derivatives sold outside the stock exchange (currency and percentage instruments) (Hodgkins 2014).

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The volume of OTC transactions on the international derivatives market significantly exceeds the volume of stock exchanges’ transactions, and in the recent decades, the share of the OTC market increased from 60% to 90%. During that time, the market volume in absolute terms has increased 133 times. The volume of stock exchange market grew approximately 30 times, OTC – 200. The world’s largest derivatives market is a North American (54%), followed by a fairly close in volumes European (38.71%). After the global financial crisis in 2008, there was a significant decline in trade on the stock exchange market, a further stabilization and a gradual increase to 70% of pre-crisis turnover in 2013. At the same time, the global OTC derivatives market almost did not respond to the crisis of 2008 (Hodgkins 2014).

Financial derivatives are very diverse in their characteristics: liquidity, availability, cost, and risk. Therefore, each instrument has its advantages and disadvantages (Hodgkins 2014).

Benefits

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. Thus, the main benefit of derivatives is hedging risks. The procedure of the previous fixation of all exchange transaction conditions would be held in the future. Consequently, it allows sellers and buyers become independent from the risk of changes in the market price of the underlying instrument during the forward period. In general, term agreements enable the division into components those risks that are inherent in the basic instruments, and simultaneously, enable redistribution of them among the participants of an agreement. It provides the possibility to trade risk separately from the basic instruments, scilicet, to implement the transfer of price risks (Madhumathi & Ranganatham 2012).

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. In this state, insure tax revenues from the oil companies. The share of such contributions is about a quarter of the state treasury. As a result of falling oil prices in the mid-eighties, the state budget has missed of $3.5 billion. Drawing the appropriate conclusions, to avoid a similar situation in the future, experts have developed a program of tax revenue hedging using options on the New York Stock Exchange NYMEX. Hedge was drafted in such a way that the minimum price of oil was fixed at $21.5 per barrel, and when the oil price grew, was provided the additional income to the Treasury (Scherer & Winston 2012).

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In addition, the positive effect from the hedging has a Singapore Airlines Ltd. It hedges approximately half of the volume of an aviation fuel consumed through futures contracts in Singapore. These operations allowed the airline to save 140 million Singapore dollars in the last fiscal year and 66 million the year before. In fact, today, the airlines of the developed countries hedge 30-60% of fuel consumed (Fedorovoa 2004).

Additionally, derivatives are means of insurance from which not only insurance companies can earn but virtually anyone. Moreover, concluding agreements with financial derivatives leads to the establishment of prices that can observe and evaluate all society. Moreover, this provides the information to individuals who are monitoring the market, in relation to the real value of certain assets and the future direction of the economy development (Madhumathi & Ranganatham 2012).

The benefits of derivatives over shares or other underlying assets are plentiful. First, it is a free shoulder, reaching a 1:50 ratio at many marketplaces. Second, financial derivatives allow earning both on the increase and decrease in the value of the instrument. Besides, playing on the decrease does not require additional expenses as on the stock market. Third, it is possible to make a profit even from stagnation on the stock market. Finally, 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 & Ranganatham 2012).

One of the most popular and successfully used types of derivative financial instruments are credit derivatives. The main advantage of using credit derivatives is the opportunity to create more efficient banking portfolios, 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. In addition to market risk management, it can serve as an instrument to attract additional investments in the project, when the bank for whatever reasons (e.g., the threat of default or regulatory authorities restrictions) is temporarily unable to purchase the asset (Madhumathi & Ranganatham 2012).

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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). Therefore, it requires a dynamic trade (i.e., it is necessary to review the structure of the portfolio when market conditions change). Thus, derivatives make market being full (add a new payment structure that cannot be reproduced with the help of existing assets) and, thus, add new capabilities to the financial system (Bouchaud & Potters 2009).

Risks

With the emergence of exchange trade forms, derivatives created favourable conditions for speculative operations. In futures stock exchanges, 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. Such approach can significantly expand the number of participants, which can be not only legal entities (banks, corporations, investment funds, insurance companies, pension funds) but also individuals. The organization of stock exchange trading forms strongly simplifies the speculative operations, allowing concluding agreements in large volumes at any time, and from another side, allowing stock speculators guarantee their forecasts and carrying out speculative operations to obtain profit from price differences (Madhumathi & Ranganatham 2012).

In the terminal market, speculators take on 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. It is clear that forecasts are not always translated into reality, and, therefore, speculators can also lose what happens frequently in practice. By some estimates, speculators lose over 75% of the money on the foreign exchanges as a result of transactions with derivatives (Madhumathi & Ranganatham 2012).

An example of risks associated with derivatives and failing speculation is Orange County. After the state of California reduced funding of counties, the Orange County became strongly depended on investments to obtain revenue. It invested in many derivatives, speculating that the interest rate would stay the same or even lower. After that, it began to purchase fixed income in the long position. Ultimately, the interest rates grew rising borrowing costs and lowering the long positions’ price. In a short time, the Orange County became a bankrupt being incapable to fulfil its obligations. Totally, it lost near $1.7 billion from such speculation (Hodgkins 2014).

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Derivatives are subject to certain risks, such as credit, market, and legal. These types of risks are not new, but using derivatives incorrectly can multiplex them repeatedly.

A credit risk is one of the main risks inherent in financial derivatives. Besides the probability of default of the underlying asset can also default a seller of protection. In this case, a buyer of protection bears a double loss. In practice, the probability of a simultaneous default on both transactions is extremely low, but it cannot be ignored. For example, the probability of a simultaneous default increases significantly when the underlying asset and the seller of protection are in the same area or are related to the same industry. Additionally, 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, and, in some cases, may be considered as a credit event (Madhumathi & Ranganatham 2012).

The market risk is speculative. 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), and decline in general regional or sectoral quotations of securities, etc. (Madhumathi & Ranganatham 2012).

A legal risk deserves special attention. The history and reputation of the counterparty may be uncertain. This factor relates to the market and the legal risk. Such factors as incomplete or insufficiently clear definition of the terms of the deal, disregard for likelihood of a merger or acquisition of a credit protection seller with the occurrence of difficulties in the implementation of previous agreements, and the unprescribed conditions of debt restructuring of the credit protection seller to the buyer in case of a credit event are directly related to the legal risks (Madhumathi & Ranganatham 2012).

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Derivative pricing theory suggests that derivatives, theoretically, do not bring to the financial system anything new, and, therefore, are redundant instruments. Thus, derivatives can be reproduced by building a portfolio of existing assets, and, thus, from the economic point of view, are excessive instruments (Bouchaud & Potters 2009).

Conclusion

The use of derivatives provides numerous advantages for economic operators, the main of which is the transformation of the financial risk considering the specified parameters of management strategy. In this sense, 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 end-users who are interested in the use of derivatives, and innovative resources of the financial sector that can respond quickly to the dynamic changes in that demand. At the same time, the use of derivatives is justified only under the condition when managers of a company or financial institution are fully aware of potential risks of specific operations. Although at transactions with derivative financial instruments arise risks of standard varieties, their practical manifestation can take new forms.

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