Financial Institutions, Markets, and Money, Eleventh Edition

CHAPTER ELEVEN

Derivatives Markets

WHAT ARE INTEREST RATES GOING TO DO? What about exchange rates? What about the stock market? Should I rise, or should I bet that the exchange rate will fall and stocks fall? How much risk can I take? Should I gamble to try to earn a higher return? Will I lose my job if my portfolio or transactions lose money? How can I protect myself and my transactions and portfolio against loss? Many bond traders, market makers, exporters and importers, and financial institutions and investment funds must ask themselves questions like these daily.

Because many people are concerned with interest rate, exchange rate, or stock market risk, the financial futures markets have grown explosively in recent years. Financial engineers developed a wide variety of financial instruments so that individuals and institutions can alter both their risk exposure and return possibilities. The new financial derivative securities derive their value from changes in the value of other assets (such as stocks or bonds), values (such as interest rates), or events (such as credit defaults, catastrophes, or even temperature changes in certain localities). Derivative securities also generate substantial fee income for the financial institutions that invent and market them.

Of course, not everyone is a fan of derivatives—especially given the role they played in the 2007–2008 financial crisis. Even back in 2002, legendary investor Warren Buffet noted, “The range of derivatives contracts ...