Political Economy of Money and Finance

Political Economy of Money and Finance 4

Political Economy of Money and Finance

Political Economy of Money and Finance

Financial derivatives

In simple terms, derivative as used in finance refers to a contract between two or more with a value that is determined by the performance of the underlying entity. Bernstein (1996) explains that financial derivatives are financial instruments that do not have value of their own. In facts, the reason why they are called derivatives is because they derive their values from other underlying financial indicators. Financial derivatives can also be defined as financial instruments that are associated with a particular financial instrument, commodity or indicator which enables trading specific financial risks in a financial market on their own rights. The underlying financial indicators which determine the value of financial derivative in the financial market include

  • Currencies

  • The rate of interests

The derivative of any financial instrument refers to the value that has been placed on the asset or other external variable mentioned above. This is what is meant by derivatives having no value of their own but depends on the performance of external variables.

Derivatives can be divided into two categories

According to Bernstein (1996), futures are contracts that are entered between a buyer and a seller where the buyer pays a fixed price for a commodity and the commodity is delivered in future times. The risk in this case is that the price of the commodity can be altered by economic factors between the time of purchase and the time of delivery. For example, Levinson, M. (2005) explains that in some cases the petroleum prices may soar. This may in turn hurt airline companies that had already sold their tickets. For this reason, they may have to pay more than is expected to operate their jets.

Options entail buying or selling a commodity at a certain prearranged price in the future to a point where both the buyer and the seller opts to sell it or into another contract.

It is important to note that when trading, the transactions in financial derivatives should be considered as separate transactions as opposed to being integral component of the value of underlying transaction to which they are connected.

Growth of Derivative Markets

Since emergence in 1970, financial derivatives have been subjected to multiple structural transformation as well as rapid expansion with regard to variance of instruments and volume of activity. This implies the last few decades the structure of commodity market has changed very quickly. Such high right of change can be attributed to the fact that markets are consistently under flux. Therefore, since derivatives are part of the market, they too are exposed to constant flux. Now derivative market is closely being monitored by policy makers and academics. In other words, derivative market has emerged from a subject of obscurity to one of intense scrutiny by supervisors and policy makers. Upheaval of access to international finance, technological inventions, liberalisation of markets and increase in global demands are some of the factors that have increased the trade and growth in derivative markets. Today, financial derivatives are traded in various institutions which include:

  • Commercial banks

  • Hedge funds

  • Private or portfolio investors

Uses of Financial Derivatives

Financial derivatives can be used for several purposes which includes

  • Risk management

  • Speculation

  • Arbitrage between different markets

Financial risks allows people to trade specific risks such as equity, currency, interstate risks and commodity price risks to individuals who are suited and willing to trade these risks. The risk encompassed in trading a contract in financial market can be traded between to people through selling the contract, like in the case of options, or by entering a new contract which specifies the same risks that were contained in the previous contracts. This concept is known as offsetability.

According Kozarevic, Jukan and Civic (2014), offsetability implies that it is possible eradicate a risk linked to derivative by creating a new contract.

Financial derivatives are traded through cash payments. This is a sure way of trading risks as independent factor from the underlying financial instruments.

Speculation in financial derivatives, on the other hand, helps is predicting the right direction in which an asset will move in future thus enhancing profit. Speculation is also a way of managing financial risks since it is used in betting which carries a significant amount of risk (Bryan and Rafferty2011).

Hedging is another critical way of managing risks. Simply stated, hedging refers to an investment made to reduce adverse movements of price which an asset may have. Hedging offsets positions in a financial market such as in future options (Munoz Martinez 2015).

Bibliography

Bernstein, P.L. and Bernstein Peter, L., 1996, Against the gods: The remarkable story of risk (pp. 1269-1275), New York: Wiley.

Bryan, D. and Rafferty, M., 2011, “Deriving capital’s (and labour’s) future.”Socialist Register47(47).

Kozarevic, E., Jukan, M.K. and Civic, B., 2014, “The Use of Financial Derivatives in Emerging Market Economies: An Empirical Evidence from Bosnia and Herzegovina’s Non- Financial Firms” Research in World Economy5(1), p.39.

Levinson, M., 2014, “The Economist Guide to Financial Markets: Why they exist and how they work” London: Profile Books

Munoz Martinez, H., 2015, “Hedging neoliberalism: derivatives as state policy in Mexico”  New Political Economy, pp.1-14.