Derivatives are basically financial instruments that derive their financial value from stocks or really goods. They are normally contracts established between two parties with a view of exchanging value in the context of stock or existing goods. Like in a typical transaction, the seller receives money in the exchange for the agreement to buy or sell goods at some future date. The greatest idea behind derivatives is that they offer leverage. In that case, one is able to take possession of goods or property they would otherwise not have accessed. The most common derivatives are futures, options, and swaps which operate slightly differently.
An option contract gives its holder the right but not obligation to engage in a transaction involving an underlying stock or real good at a predetermined future date and price (Groz, 2007). A call option gives the holder the right to purchase underlying security while a put option grants the holder the right to sell an underlying security. Most options are designed to provide a choice on when the contract will be exercised. Futures, on the other hand, are agreements to conduct a transaction at a future date in which case all the pertaining aspects of the transaction including price, quantity, and delivery date are agreed upon at the present while the actual transaction occurs at a future date. In that case, the buyer of the futures contract is legally obligated to give money which equals the contract price while the seller is legally obligated to deliver the goods agreed. A swap is also an agreement that occurs between two parties to exchange cash flows for a specified timeframe. The major motive behind most financial derivatives is the need to hedge against future uncertainties which may impact negatively on businesses. On the other hand, speculators use financial derivatives such as futures to basically take advantage of economic fluctuations.
A financial system is a nexus of financial institutions, markets, and services that facilitate the transfer of funds within an economy. The prevailing financial system in an economy greatly determines the economic growth of that economy. In that case, the system plays a very integral role in any modern economy, especially at the present age. Considering that investment drives the wheels of an economy, the financial system links the savers and the borrowers so as to enhance investment. The payment system and mechanism in an economy are fully a function of the existing financial system. In terms of risk, the financial system plays a great role in risk minimization by ensuring diversification of the financial activities in the economy. It also helps in the assessment of financial claims by making them more liquid. The financial institutions in a country normally comprise deposit-taking institutions like banks, insurance companies, asset finance companies, pension funds, and capital market institutions. These institutions provide a wide range of varied services that govern the financial market. The major financial instruments issued in a financial system normally include treasury bills, treasury bonds, and the commercial papers mostly issued by companies. Treasury bills are short-term financial instruments issued by the government to finance budget deficits. Treasury bonds on the other hand are long-term in nature and are issued by the government to finance long-term programs like infrastructure development. A certificate of deposit is a financial instrument that is normally evidence that a time deposit has been placed with a depository institution (Weston, 1999). In a financial system, most savers approach financial institutions to keep most of their surplus money, these institutions on the other hand lend this money to willing borrowers who in turn pay with interest. In that manner, money moves from savers to borrowers.
References
Groz, M. (2007). Foundations of Finance. New York: Basic Books.
Weston, J. (1999). Financial Theory. West Sussex: Addison Wesley.