What are Financial Derivatives?
Financial Instruments are the financial derivatives, used by their own rights in the financial markets to trade financial risk; they are associated with financial commodity, instrument or indicator. Instead of treated transactions as an integral part of the important principal transactions to those they might be linked they are treated as separate transactions. The cost of a fundamental item that may be an index or an asset, determined the value of financial derivative. Contrasting to debt instrument no investment occurs and repayment of principal amount must have to be paid. There are a lot of uses of monetary derivatives such as hedging, risk management, and arbitrage between speculation and markets.
The greatest advantage of financial derivative is they facilitate the parties in trading different financial risks i.e. currency, equity, rate of interest, credit risk and price of a commodity etc. to the other entities that are better suited , manage and take risks, and sometimes it happens without trading the asset and commodity or asset. There are two ways to trade the risks relating to derivative:
- By dealing the agreement like with different options
- By creating the new contract that took place in the forward markets and named as offsetability.
The term offsetability refers it is possible that risks can be eliminated that is related to the derivatives by making a new contract having the characteristics to countervail the risks associated with the previous derivative. Selling the old derivative is handy equivalent to the buying the new one with elimination of chances of risks. Therefore tradability in the agreed value is considered equivalent to the ability to substitute the risk. Actual offsetting of the derivative is not essential to reveal the value but an outlay is required that represents the value the contract of current derivative.
Net cash payments are required to settle the contracts of the financial derivatives. And mostly it occurs prior the maturity for trading contracts like futures commodity. In order to trade risk of the financial derivative independently of a fundamental items’ ownership the logical component is cash settlement. Thus, those financial derivatives especially that involve the foreign money is related to the transaction in the item that is underlying.
1993 SNA (System National Accounts)’s edition and the BPM5 that is an IMF’s Manual of Balance Of payments published and understanding and knowledge that the market of financial derivatives id deepened and also indicated the need for review of statistical treatments that should be appropriate. So in 1997 a dialogue paper is produced by IMF named as “The Statistical Measurement of Financial Derivatives” that implemented by the Committee on the Payments Statistics Balance of IMF. The characters of financial derivative is reaffirmed but it proposed that financial derivatives should be treated as financial assets and result also proposed that change is necessary in handling of the interest rate and FRAs “(forward rate agreements)” as a result income of property accounts documented in the financial accounts and treated as financial assets. For the financial instruments there in the national accounts a separate instrument is created and a separated category has made in the payments balance.