One of the strengths of derivatives is that they can be combined in many ways to create new risk management solutions. Similarly, banks and securities houses can use derivatives to create new families of investments aimed at the institutional and retail markets.
Products can be developed with a wide range of risk and return characteristics, designed to appeal to different categories of investors in different market conditions. The choice is no longer limited to buying bonds or shares or placing money in a deposit account. Derivative instruments can create securities whose returns depend on a wide range of variables, including currency exchange rates, stock market indices, default rates on corporate debt, commodity prices - even electricity prices or the occurrence of natural disasters such as earthquakes.
Attitudes to Risk
Some structured products are aimed at the more cautious or risk-averse investor. They incorporate features that protect at least some percentage of the investor’s initial capital. Others actually increase the level of risk, for those who wish to achieve potentially higher returns. Chapter 1 discusses some of the potential pitfalls.
Derivatives also allow financial institutions and corporations to ‘package up’ and sell off risky positions to investors who are prepared to take on those risks for a suitable return.
Chapter 18 gives an example of the technique. A company that owns a cross-holding in another firm’s equity ...