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Financial Derivatives

A derivative in finance is understood as a financial instrument that is accorded a value that is entirely based on the future speculation of price movements of assets to which are often linked to other assets such as currencies, stocks, commodities, bonds, interest rates, shares. In other words a derivative can be understood as an asset that derives its value from another existing asset. The derivative is by itself a mere contract that exists between a given numbers of parties. The value of the derivative depends on the fluctuation or the leverage of the other asset that it has been associated with or commonly referred to as the underlying asset (Chance & Robert 2009). For instance, a call option on the inventory of Pepsi can be a termed to as a derivative security which obtains its value from the shares of Pepsi that can be bought during the call option duration. In a number of instances, a derivative can be associated with a high or low risk investments, this entirely relies on how the each given specific derivative is used. A risk on the other hand is related to unforeseeable future occurrences that may lead to damage or losses. A good example is trade between foreigners where each may be placed in a compromising situation or may be at risk of undergoing losses in relation to the exchange rates (Ariff 2007). To minimise and control this risk, this investor is forced to buy currency futures in specific or predetermined exchange rates to be used in the future dealings after being converted back to foreign currencies.

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