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Executive Summary
This firm is one of the world's leading exchanges for money market and derivatives trading, supporting billions of dollars worth of trades per day.This firm began in the early 1980s as a commodities and futures exchange that was specifically designed to offer institutions access to investments in foreign markets. This firm now offers customers a broad portfolio of derivatives products including short term interest rates (STIRs), bonds, swaps, equities, and commodities.To understand the value of the services provided by this firm and to understand the volume of transactions this firm processes, it is helpful to understand how derivatives work. Although the discussion of derivatives might seem indulgent, I believe the concept of balancing exposure, risks, and rewards is analogous to the concept of early adoption and innovation, specifically with regard to implementing new technology.Derivativesspecifically options, swaps, and futuresare financial instruments used by private individuals and institutions to create wealth and to balance portfolios. At minimum, a derivative can be described as an investment whose worth is tied to the valuation of a wholly separate and distinct financial instrument.Derivatives allow individuals who desire increased levels of risk, or alternately, reduced exposure to risk, to hedge against fluctuations in broader markets and to protect (and ostensibly to increase) revenue streams associated with their investments.
How Derivatives Work
Here follows a brief discussion of how derivatives can be used to minimize risk and protect income. Because the value of the derivative is abstracted from the value of the underlying asset, it is possible to construct complex financial management strategies and to build portfolios comprised of investments in both the principle asset and a set of derivative assets whose values can rise or fall in opposition to each other. Three of the most common examples of derivatives are options, swaps, and futures.Options tend to work in the following manner: Investors might hold an equity position as a long-term investment with the understanding that the value of the asset might decline over time. To recognize revenue from the asset, the owner must liquidate his position in the asset. An option is a contract that offers the right to purchase or sell a position in a particular asset at a fixed price by a certain date in time. The purchase of an option does not require ownership of the underlying asset. An option to sell (put) or an option to buy (call) retains value until the time of its expiration. Ownership of an option can significantly minimize the risk involved with a long-term equity position.In a similar manner, corporations and financial institutions often use swaps and futures to minimize the risk inherent in holding large positions in volatile currencies and commodities.
