Purposes and Criticism of Derivative markets

Purposes and Benefits
· Speculation - derive profit from changes in interest rates, equity markets, currency exchange rate, global supply and demand for commodities.
· Price Discovery
· Risk Management - help hedge against inflation and deflation, and generate returns that are not correlated with more traditional investments
· Improve market efficiency for the underlying asset
· Help reduce market transaction costs

Criticisms
· Sophistication - potential for huge gains and huge losses, appropriate for only sophisticated investors with a high tolerance for risk.
· Lifespan - as each day passes and the expiration date approaches, more and more "time" premium lose and the option's value decreases.
· Direction and market timing - investors must accurately predict the direction in which the market or index will move during a set period of time. A mistake here almost guarantees a substantial investment loss.
· Costs - The bid/ask spreads of more common derivatives such as options can be daunting.

Futures, forwards, Options, Swap

Forwards
· negotiated privately in the OTC market, customized,
· do not have any margin requirements
· do expose the parties to credit risk.
· Have uniqure contract, have default risk.
· Require no cash transaction until delivery date, usually not regulated

Futures
· Standardized
· exchange-traded contracts that are more liquid and so cheaper than forwards.
· Futures buyers and sellers must deposit a margin with the exchange/clearing house.
· Futures have near-zero credit risk. Regulated.

Options
Contracts that give their owners the right, but not the obligation, to conduct a transaction in the future, whose terms are set in the option contract.

Call option - provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time.

Put option - give the holder the right to sell an underlying asset at a specified price (the strike price).

Swaps
· Contracts for the exchange of two or more sets of cash flows between two parties.

Forward Commitments vs. Contingent claim

A forward commitment is a contract between two (or more) parties who agree to engage in a transaction at a later date and at a specific price.

Two major types of forward commitments:

Forward contracts, or forwards - OTC-traded derivatives with customized terms and features.

Futures contract, or futures - exchange-traded derivatives with standardized terms.

Exchange-traded vs. over-the-counter derivatives

Derivatives
Derivatives are financial contracts or securities whose payoff depends on underlying assets or indices.
Exchange-traded derivatives
· Traded on established exchanges (the New York Stock Exchange, the French CAC or the Chicago Board of Trade).
· Highly standardized terms and features.
· The regulated exchanges provide clearing and regulatory safeguards to investors

Over-the-counter or OTC-traded derivative
· Traded outside of the formal, established exchanges, including forwards, swaps and exotic derivatives
· Can be created by any two counterparties with highly flexible terms and a nearly infinite number of underlying assets or asset combinations
· Large financial institutions serve as derivatives dealers to customize derivatives for the specific needs of clients