When one thinks of the stock market, the idea that comes to mind is a group of brokers shouting in a pit looking for the best price to get an asset. The concept of the trading pit has been replaced by a computer screen,however, the concept still holds that it is seen as a market where only shares are traded. There is a complex web of financial products that are built on top of this basic structure which is used by the market participants for different purposes. Essentially, the role of the market is to facilitate trading to take place which allows certain parties to sell away their risk to someone who is willing to take on additional risk for an additional return.
In order to facilitate this transfer of risk, a whole range of financial products have been developed in order to make this possible. The concept of financial alchemy has been developed over time which allows for financial products to be designed which help one person to shift their exposure to risk to someone who is willing to take on the additional risk in order to make an additional gain.
Derivatives have been developed which offer a different risk and return outlook to an investor as they derive their value from underlying assets. The difference is that rather than investing directly in the underlying asset, the investor is able to invest in a product whose value is linked to the asset. An example that can be considered here are the future contracts. Rather than buying a share of a company, the investor buys or makes a promise that he will purchase the share at a future date and will take ownership of the share later.
This allows the investor to be able to put up a smaller amount of investment currently and have an interest or an exposure to the profit that the share will earn. Once the basic tenets are set, these futures are used to create a synthetic position by shareholders where they are able to sell their shareholding in the market and then buy the shares in the future market.
This tool is now being used extensively by companies and their shareholders to be able to get the funds now and then commit a smaller amount to buy the shares in the future market. In this manner, they are able to stake a claim to these shares while being able to sell them. The last layer of complexity that is added on top of this is that these shareholders are able to roll over their position ad infinitum allowing them to virtually own the shares while getting access to funds by selling their shares.
Confused?
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