Derivative Valuation

June 19, 2012 by  Filed under: Management 

Derivatives are instruments created as part of a contract between two parties. Derivatives generally list the specific conditions which must be met in order for payments to be made. Because of the special legal exemptions afforded derivatives, they are very popular as a form of credit. On the other hand, derivatives are very complex and derivative valuation can lack transparency. This can lead to hidden credit risk. Some point to the use of derivatives to hide credit risks as one of the causes of the current American financial crisis. For this reason alone many investors have called for more transparency in derivative valuation.

These changes in do not seem to be forthcoming. The financial crisis seems to have shrouded the derivatives market in even more secrecy and government intervention. This has given many investors pause and may even be slowing the recovery. Derivatives have been in use since the 18th century. They are often used as hedges against losses. The lack of full disclosure which has grown up around derivatives has made them misunderstood by all but the most knowledgeable investors. This has placed them out of reach of the average investor. Even experienced investors are often put off by all the secrecy.

Derivatives can be purchased as a forward, swap or an option. They are used with a variety of assets including stock, commodities, interest rates, equity or foreign exchange. People often use them as a way to protect their investments. Some of them relish the fact that derivatives valuation is closeted in government legislation and mystery. It gives them an upper hand over people with whom they are doing business. They also say it protects them from unscrupulous individuals who would use derivative prices to pretend to predict uncertain future prices.

Still, if more derivatives valuation were transparent the public and private investors would be better served. It would reduce dangerous speculation and protect people who invest in derivatives from being mislead. Derivatives are tried and true investment vehicles. They have been used for over 200 years. They can be traded over the counter, through an exchange or through personal contracts. Derivatives are tried and true financial instruments. But the derivatives market has now become clouded by uncertainty. Investors are being kept in the dark about the true value of their investments and run the risk of being taken advantage of without the transparency of the valuation of their derivatives.

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