Bond and Derivatives Market Innovations

Essay by DavidNscoUniversity, Bachelor'sA+, June 2006

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1. Introduction

In today's global and hypercompetitive business environment, many companies are forced to diversify their source of funding, particularly when future growth is intended. A successful firm expansion requires "fueling" from various funding supplies, besides the ordinary sales revenues.

These alternative financing sources, which are needed by the firms, are provided by the financial system. The demanded financial products are created by intermediation, which is truly the most important role of the financial institutions. They act as a "link" between the surplus and deficit units - get between and match both bodies. Likewise they generate liquidity by producing both assets and liabilities (Studart, 1995).

2. Bond Market Innovations

Apart from the standard investment options offered in the bond markets, in the last 30 years many financial innovations were developed. These innovations are beneficial to both, borrowers and lenders, each having different characteristics specifically tailored to satisfy the diverse customers' preferences.

However, the lenders and borrowers have to thoroughly understand how these innovations suit their needs and in what way are they related with the other elements of the economy.

In the following sections several financial innovations in the securities market are systematically analyzed, and their purpose and risk management is presented.

2.1 Callable and Putable Bonds

One of these innovations is the callable bond. Basically it grants the issuer right to buy back the already issued bond at a prearranged price over a specific period of time before maturity. This implies that the issuer is protected from the interest rate volatility, which might increase the rate of "coupon" payments needed to be repaid to the bond holder. They are usually used by the firms operating in an unstable economy, where interest rates are subject to frequent change (The Bond Market Association, 2005).

According to Robbins and Schatzberg (1986) the...