From Riski

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying ). The underlying value on which a derivative is based can be an asset (e.g. commodity, equities, residential mortgages, commercial mortgages, loans, bonds), an index (e.g. interest rates, exchange rates, stock market indices, consumer price index (CPI) — ie inflation derivatives), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwards, futures, options, and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

Contents

Uses

Hedging

Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market’s current assessment of the future value of the asset.

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.

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 futures contracts. Through a combination of poor judgment, lack of oversight by the bank’s management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.[1]

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 derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds.

Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange.

According to the Bank for International Settlements. the total outstanding notional amount is $684 trillion (as of June 2008) OTC derivatives statistics report, for end of June 2008, shows $683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of $20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics .)

Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS). 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other.

Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.

• 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 [1] 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 and the 2008 acquisition of the New York Mercantile Exchange ). 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 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:

1. Futures /Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves.
2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option ) or sell (in the case of a put option ) an asset. The price at which the sale takes place is known as the strike price. and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option. the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option. the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.
3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

Examples

Some common examples of these derivatives are: