Academic journal article Economics, Management and Financial Markets

The Healthy Functions of Using Derivative Financial Products within the Non-Financial Companies. Arguments for Using Them in Romania

Academic journal article Economics, Management and Financial Markets

The Healthy Functions of Using Derivative Financial Products within the Non-Financial Companies. Arguments for Using Them in Romania

Article excerpt

1. Introduction

The derivative financial products are the tools whose value results from the value of the assets which stand at their basis such as the shares, bonds or currency. The price of the derivative products may be established by constructing a replica portfolio (i.e., we can buy directly the assets which stand at their basis and which function in the same way as the derivative products). This could imply that the derivative products are useless assets. And then why is there such a fuss around them? If it is true that everyone could create a portfolio of assets which could function as an exact replica of the derivative product, the ban on the derivative products would change nothing as long as the transparency obligations for these portfolios would be the same as those for derivative products. Instead of buying a purchasing share option, an investor could create a portfolio equal with the above mentioned option. Supposing that the model of establishing the price of the derivative products that the financial markets do not have any frictions (that means they are perfect) we could state that this assumption is fully oversimplifying. This assumption could be taken for granted only for the companies having large operations which can trade quite often and low cost in order to manage well the replica portfolio of the derivative products on the liquid enough markets. Also, these companies could be market-makers and find easily tradeoff for the trades they want to perform. If this happens, then they do not need hedging anymore.

As far as the non-financial companies and individuals are concerned, the derivative products are almost never useless. There are many reasons for this. Firstly, the non-financial companies and individuals face trade costs bigger than any other profitable financial institution. Generally speaking, many investors and commercial companies consider that it is very expensive to create a portfolio able to bring the same differential as a purchasing option. Secondly, the strategy of managing a replica portfolio for the derivative products based on the features of an option needs a transaction every time the price of the support asset changes. In this light, the replica portfolio functions almost the same as the derivative product. Thirdly, identifying a fair strategy for the replica portfolio is often quite an issue. For example, the strategy can be different in terms of the dynamics of the prices of the support asset so that the estimation errors could affect the performance of the strategy and this approach can become risky. Because of these problems, the companies and individuals will be willing to pay the financial institution for providing a derivative product instead of trying to create one by them.

2. The Advantages of Using Derivative Products

The main advantage of the derivative products is to allow the individual investors and the commercial companies to get revenues which otherwise could not be obtained without derivative products or could be obtained at higher costs. Due to the fact that the companies and individuals cannot get efficient revenues from derivative products by using a replica portfolio, the derivative products make the markets more complete and cover the risks which otherwise would be uncoverable (for these investors and companies). When the investors and companies can manage the risk better, they will choose riskier, but more profitable, investment projects. As a result, the economy will become more productive and the welfare more obvious.

Another important yield of the derivative products is that they can make the market of the support assets become more efficient. In this way, the derivative markets produce information. For example, in many countries, the only safe information related to the interest rates in the long run is taken from the swap markets, because this is more liquid and active than the bond market. The derivative products also allow the investors to trade using this information. …

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