TAILIEUCHUNG - Derivatives the tools that changed finance

A derivative is a contract that is used to transfer risk. There are many different underlying risks, ranging from fluctuations in energy prices to weather risks. Most derivatives, however, are based on financial securities such as common stocks, bonds and foreign exchange instruments. | 1 Introduction A derivative is a contract that is used to transfer risk. There are many different underlying risks ranging from fluctuations in energy prices to weather risks. Most derivatives however are based on financial securities such as common stocks bonds and foreign exchange instruments. This chapter will explain in broad terms the following points what derivatives are how they are used how derivatives can reduce risks such as price risk how they can also increase risk - the aspect of derivatives that receives most attention from the media how some recent derivatives disasters occurred and the ways in which some basic derivative contracts such as forwards options swaps and futures work. Derivatives have changed the world of finance as pervasively as the Internet has changed communication. Their growth has exploded during the last 30 years as ever more risks have been traded in this manner. By the end of 1999 the estimated dollar value of derivatives in force throughout the world was some US 102 trillion - about 10 times the value of the entire US gross domestic Insurance is the traditional method for sharing risks. We will use the concept of insurance when discussing derivatives because insurance is a familiar notion and most people understand it. However although insurance and derivatives share common features in that they are both devices for transferring risk there are also distinct differences. The risks covered by insurance are generally different from those that are dealt with by derivatives. We first need to clarify the meaning of the word risk . Risk has a specialised meaning in an insurance context it refers to the chance that a future event might happen with bad consequences for somebody - for example an airline might lose someone s baggage. This event is uncertain in that it may or may not happen. If it does not happen you are no worse off but if it does there is an adverse consequence that could involve an economic loss or something .

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