Financial Derivative Case Studies
INTRODUCTION
Financial derivatives have crept into the nation 's popular economic vocabulary on a wave of recent publicity about serious financial losses suffered by municipal governments, well-known corporations, banks and mutual funds that had invested in these products. Congress has held hearings on derivatives and financial commentators have spoken at length on the topic.
Derivatives, however remain a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products.
In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad." When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy.
DERIVATIVES:
A derivative is a contractual relationship established by two (or more) parties where payment is based on (or "derived" from) some agreed-upon benchmark. Since individuals can "create" a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there is no definitive list of derivative products.
Why Have Derivatives?
Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes. For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay
Financial derivatives have crept into the nation 's popular economic vocabulary on a wave of recent publicity about serious financial losses suffered by municipal governments, well-known corporations, banks and mutual funds that had invested in these products. Congress has held hearings on derivatives and financial commentators have spoken at length on the topic.
Derivatives, however remain a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products.
In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad." When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy.
DERIVATIVES:
A derivative is a contractual relationship established by two (or more) parties where payment is based on (or "derived" from) some agreed-upon benchmark. Since individuals can "create" a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there is no definitive list of derivative products.
Why Have Derivatives?
Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes. For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay