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Derivatives are financial instruments whose value is derived from the value of something else. The main types of derivatives are futures, forwards, options, and swaps.
The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.
Uses
Insurance and Hedging
One use of derivatives is as a tool to transfer risk by taking the opposite position in the futures market against the underlying commodity. For example, a wheat farmer and a wheat miller could enter into a futures contracts to exchange cash for wheat in the future. Both parties have reduced the risk of the future: the uncertainty of the price and the availability of wheat.
Speculation and arbitrage
Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.
In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgement on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old financial institution.
Types of derivatives
OTC and exchange-traded
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:
- Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 516 trillion (as of June 2007)[1].
- Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade). According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs(tm) and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.
Common Derivative contract types
There are three major classes of derivatives:
- Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
- Optionals, which are contracts that give a holder the right to buy or sell an asset at a specified future date.
- Swappings, where the two parties agree to exchange cash flows.
Examples
Some common examples of these derivatives are:
Other examples of underlying exchangeables are:
Portfolio
It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. They simply derive their values from assets such as bonds, equities, currencies, etc. and are used to either hedge those assets or improve the returns on those assets.
Cash flow
The payments between the parties may be determined by:
- the price of some other, independently traded asset in the future (e.g., a common stock);
- the level of an independently determined index (e.g., a stock market index or heating-degree-days);
- the occurrence of some well-specified event (e.g., a company defaulting);
- an interest rate;
- an exchange rate;
- or some other factor.
Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.
Valuation
Market and arbitrage-free prices
Two common measures of value are:
- Market price, i.e. the price at which traders are willing to buy or sell the contract
- Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing
Determining the market price
For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.
Determining the arbitrage-free price
The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black-Scholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model.
Controversy
Derivatives are often subject to the following criticisms:
- The use of derivatives can result in large losses due to the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, including:
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- The Nick Leeson affair in 1994.
- The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded.
- The bankruptcy of Long-Term Capital Management in 2000.
- The loss of $6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
- The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of forward contracts.
- Derivatives (especially swaps) expose investors to counter-party risk. For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate. This chain reaction effect worries certain economists[citation needed], who posit that since many derivative contracts are so new, the effect could lead to a large disaster. Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis. This has been a cause for concern among many economists[citation needed].
- Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it.
- Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by legendary investor Warren Buffett in Berkshire Hathaway's annual report. Buffet stated that he regarded them as 'financial weapons of mass destruction'. The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. Many economists[citation needed] are worried that derivatives may cause an economic crisis at some point in the future.
- Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression.
Nevertheless, the use of derivatives has its benefits:
- Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system[citation needed]. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.
- Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.
Definitions
- Bilateral Netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal obligation covering all included individual contracts. This means that a bank’s obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.
- Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default options, credit limited notes and total return swaps.
- Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.
- Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the bank’s counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties.
- Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral.
- High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities.
- Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional.
- Over-the-counter (OTC) derivative contracts : Privately negotiated derivative contracts that are transacted off organized futures exchanges.
- Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and/or have embedded forwards or options.
Footnotes
- ^ BIS survey: The Bank for International Settlements (BIS), in their semi-annual OTC derivatives market activity report from November 2007 that, at the end of June 2007, the total notional amounts outstanding of OTC derivatives was $516 trillion with a gross market value of $11 trillion. See also OTC derivatives markets activity in the second half of 2004.)
- ^ Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website.
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