Financial instruments: future and derivatives

Market - place where sellers and buyers meet together.

Types of markets: Terminal – the market dealing mainly in commodities that will be avaliable in future (FUTURES) rather than goods that are available immediately (ACTUALS); Stock market is the market where stocks and shares are bought and sold under fixed rules, but at prices controlled by supply and demand.

Stock markets could be classified: According to territory: international, national/domestic, regional; According to the number of transferrings: Primary markets issue and trade new securities, an investor who purchases new securities is participating in a primary financial market; and secondary markets which trade previously issued securities, an investor who resells existing securities is participating in a secondary financial market. According to the company status and place of sale there are two basic types of stock markets – organized exchanges, like the New York Stock Exchange (NYSE) or the London Stock Exchange (LSE) which trade listed/quoted securities for/of successfully growing companies and the less formal o ver-the-counter markets that sell and buy unlisted securities for/of smaller and newer companies. The prices of the securities are established by supply and demand. According to tendencies: a bear market when share prices fall because there are more sellers than buyers and a bull market when share prices rise because there are more buyers than sellers. According to maturity: money markets which deal in short –term securities having maturities of one year or less capital markets which deal in long-term securities having maturities more than one year.

Bulls are people who buy securities expecting their price to rise so they can resell them before the next settlement day. Bears sells shares hoping to buy them back at a lower price before the next settlement day. Stags are people who buy new share issues, hoping to resell them at a profit (if the issue is over-subscribed it).

securities can be classified: 1. According to the form of raising the capital (financing): Debt securities (bonds). It’s a promise by the company or government to pay back a certain amount of interest over a definite period of time.; Equity securities (shares). A share gives its holders the part of ownership of a company. 2. According to the issuer: Industrial and commercial; Government; Municipal; 3. According to the form of issuing: Scrip; Inscribed; 4. According to the holder: Registered; Bearer; Order; 5. According to the term of circulation: Long-term; Short-term; 6. According to the resource the security is based on: Primary; Secondary; 7. According to the investment qualities: Liquidity; Risk involved; Yielding.

The word “derivatives ” is a general name for financial instruments whose price depends on the movement of another price.

Futures are contracts to buy or sell fixed quantities of a commodity, currency, or financial asset at a future date, at a price fixed at the time of making the contract. They are different from forward contracts, because they can be sold only on stock exchanges. Futures are standardized deals for fixed quantities and time periods and forward contracts are individual, non-standard, “over-the-counter” deals.

Hedging means making contracts to buy or sell commodity or financial asset at a pre-arranged price in the future as a protection or “insurance” against price changes; Speculation i s the process of buying securities or other assets in the hope of making a capital gain by selling them at a higher price or by buying them back at a lower price. Options are contracts giving the right, but not the obligation, to buy or sell a security, a currency, or a commodity at a fixed price during a certain period of time. A call option gives the right to buy securities (or currency, commodity) at a certain price during a certain period of time. A put option gives the right to sell as asset at a certain price during a certain period of time. These options allow organizations to hedge their equity investments. Options and short selling allow a speculator to profit from movements in stock’s price without holding the stock itself.

Many companies nowadays also arrange currency swaps and interest rate swaps with other companies or financial institutions. Swaps can be defined as transactions in which two parties swap financial assets by linking a foreign exchange transaction in cash to an opposite futures business in the same currency, financial instruments designed to achieve interest rate savings.

All types of derivatives have recently begun to appear regularly in the news as various banks, companies and local governments have suffered serious problems or even bankruptcy as a result of using derivatives. For example, in the mid-1990s some of such institutions made spectacular losses with derivatives. The most famous was Barings Bank, which was bankrupted when a single trader in Singapore lost over $1 billion by speculating disastrously on futures and options on the Nikkei 225 stock index. Or, for instance, a multinational company “Procter & Gamble” also lost over $100 million on interest rate swaps. For such giant losses there are, of course, some reasons.: 1. banks are as much to blame as the end-users in taking on risks or misusing derivatives; 2. management don’t have a clear policy on derivative usage; 3. some people use the same derivatives for both hedging and speculating. The ways to avoid losses can be like that: 1. If a derivative is used to take on risk, to increase returns, then it requires a more hands-on management approach. A company needs stop-loss limits, it also needs to conduct scenario analysis to see how that transactions behaves under various conditions and it has to judge whether the Profit and Loss account’s impact of that transaction can be withstood in the firm; 2. Any industry has to realize that it has to police itself, because, if they don’t police themselves the regulation will come on them; 3. The major risk of a transaction have to be explained to customers, and the sensitivity and scenario analysis should be offered unsolicited to customers, and that these analyses should be done as objectively as possible; 4. And the last and the most important fact, as I think, that an understanding of derivatives should came from senior management themselves to front line managers.