Financial innovations refer to the generation of new and creative approaches to different financial circumstances such as money management and investment. In any situation, it is all about offering new ideas and financial instruments that have the potential to be extremely desirable in the long run. In general, financial innovation refers to creating and marketing new types of securities. Categories of financial innovation include: financial systems/institutional innovations, process innovations, product innovations.
Derivatives are financial contracts whose values are derived from some underlying assets. The assets can include equities, bonds, exchange rates, commodities, residential and commercial mortgages. The contract specifies the conditions such as dates and the resulting values of the underlying assets, under which the payments or pay-offs, are to be made between the two parties. The most common forms of these contracts include options, forwards/futures and swaps.
History shows that financial innovations have been a critical and persistent part of the economic landscape over the past few centuries. In the years, financial markets have continued to produce a multitude of new products including many new forms of derivatives, alternative risk transfer products, exchange traded funds, and variants of tax-deductible equity. The first exchange for trading derivatives appeared to be the Royal Exchange in London which permitted forward contracting. When seen from a distance, financial innovation is an on-going process.
Financial innovations, often new kinds of derivative, arise so as to enhance growth by increasing credit availability. They are useful in managing risk, pooling funds, moving funds across time and space, extracting information to support decision-making, addressing moral hazards and asymmetrical information problems and facilitating sale and purchase of goods and services through a payment system (Merton, 1992). On the other hand, derivatives increase credit by allowing investors to hedge risk. They also provide leverage, speculate and make profit if the value of the underlying assets moves the way they expect. Furthermore, it helps obtain exposure to the underlying where it is not possible to trade in them.
Financial innovation has been both praised as the engine of growth of society and castigated for being the source of the weakness of the economy. They are divided across four functions of financial system: payments, savings, investments and risk-bearing. Derivatives are powerful financial instruments which may cause trouble when used inappropriately. Therefore, financial innovation and derivatives have great implication on global financial system.