Derivatives

Derivatives are tools for transferring risk. They are now widely used in the business world but a few decades ago derivatives were obscure financial instruments. They were mainly used to manage the price risk of commodities like wheat in a market that was relatively small. From these humble rural beginnings, the market expanded spectacularly. Derivatives are now available on an extensive range of risks, from interest rates to electricity prices. There has been a tremendous amount of financial innovation in the design of these products and this has resulted in an extensive variety of contract designs. The derivatives market transcends national boundaries and is now a truly global market. Today the market for derivatives is the largest financial market in the world. Despite their importance, derivatives are not well understood. One reason is that they have acquired the reputation of being complicated, technical instruments. This view is widespread in the media. In a Fortune article, Carol Loomis described derivatives as being “concocted in unstoppable variation by rocket scientists who rattle on about terms like delta, gamma, rho, theta and vega, they make a total hash out of existing accounting rules and even laws.” The CBS show “Sixty Minutes” stated also, that: “Derivatives are too complicated to explain and too important to ignore”. The authors agree that derivatives are too important to ignore but do not agree that they are too complicated to explain. The main aim of this book is to explain in simple terms what derivatives are and, in some respects, derivatives are no more complicated than insurance. The average person usually has a good, basic understanding of insurance, therefore we hope it is possible to create the same level of awareness of derivatives

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