Explanation of Financial Derivatives & Financial Intermediaries

Financial markets permit businesses and governments to raise the funds needed by the sale of securities. The economy requires a sound financial market for its proper functioning.

Explain in detail financial derivatives and the financial intermediaries.

Explanation of financial derivatives

Derivatives are financial instruments that have no intrinsic value but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations. The term ‘derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the cash asset.

A derivative contract or product, or simply „derivative‟, is to be distinguished from the underlying cash asset. The price of the cash instrument is referred to as the „underlying‟ price.

There are two types of derivative securities that are of interest to most investors- futures and options.

A futures contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. The party which agrees to purchase the asset is said to have a long position and the party which agrees to sell the asset is said to have a short position.

An Option is a right but not the obligation of the holder, to buy or sell an underlying asset by a certain date at a certain price. The option represents a special kind of financial contract under which the option holder enjoys the right but has no obligation to do something.

Explanation of financial intermediaries

Financial intermediaries channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments.

In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds. The major intermediaries are commercial banks, mutual funds, life insurance companies, and finance companies.

The financial intermediaries are intermediate between the providers and users of financial capital. The financial intermediaries raise funds by taking deposits and/or issuing securities (and, in the process, they incur liabilities). They then use these raised funds to acquire financial assets by making loans and/or purchasing securities.

This set of activity is known as financial intermediation. The reasons why intermediaries such as banks exist are related to the various market imperfections, in particular, imperfect information.

Financial institutions such as banks and insurance companies are important sources of financing for businesses. They enable the flow of capital from the people and institutions (which have savings) to the businesses and individuals who need financing. Financial institutions provide a payment mechanism for the economy and offer risk pooling, loans and deposits, and other services to their customers.

Also read about Investment Process & Common Errors in Investment Management

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