Derivative (finance)
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[[Image:Chicago bot.jpg|right|300px|right|thumb|Derivatives traders at the [[Chicago Board of Trade]].]]
'''Derivatives''' are [[financial instrument]]s whose value changes in response to the changes in underlying variables. The main types of derivatives are [[futures contract|futures]], [[forward contract|forwards]], [[option (finance)|options]], and [[swap (finance)|swaps]].
The main use of derivatives is to reduce [[risk]] for one party.{{Fact|date=July 2008}} The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives [[contract]]s available to be traded in the market. Derivatives can be based on different types of assets such as [[commodity|commodities]], [[equities]] ([[stocks]]), [[Bond (finance)|bonds]], [[interest rate]]s, [[exchange rate]]s, or indexes (such as a [[stock market index]], [[consumer price 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==
{{finance}}
===Hedging===
One use of derivatives is to be used as a tool to transfer [[risk]] by taking the opposite position in the underlying asset. For example, a wheat farmer and a wheat miller could enter into a [[futures contract]] to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.
Also, stock index futures and options are known as derivative products because they derive their existence from actual market indexes, but have no intrinsic characteristics of their own. In addition to that, one of the reasons some believe they lead to greater market volatility is that a huge amounts of securities can be controlled by relatively small amounts of margin or option premiums.{{Fact|date=July 2008}} One reason derivatives are popular is because they can be transacted [[Off-balance-sheet]].{{Fact|date=July 2008}}
===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.{{Fact|date=July 2008}} 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 (finance)|volatility]] of the underlying security. This technique is commonly used when speculating with traded options.
{{POV|date=July 2008}}
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 [[1000000000 (number)|billion]] loss that bankrupted the centuries-old financial institution.{{Fact|date=July 2008}}
==Types of derivatives==
===OTC and exchange-traded===<!-- This section is linked from [[Financial instrument]] -->
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:
* '''[[Over-the-counter (finance)|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 [[swap (finance)|swaps]], [[forward rate agreement]]s, and [[exotic option]]s 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)<ref name="afgh">'''BIS survey''': The [[Bank for International Settlements]] (BIS), in their semi-annual [http://www.bis.org/publ/otc_hy0711.htm OTC derivatives market activity] report from November 2007 that, at the end of June 2007, the total [[notional amount]]s outstanding of OTC derivatives was $516 trillion with a [[gross market value]] of $11 trillion. ''See also [http://www.bis.org/press/p050520.htm OTC derivatives markets activity in the second half of 2004]''.)</ref>.
* '''Exchange-traded derivatives''' (ETD) are those derivatives products that are traded via specialized [[derivatives exchange]]s 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<ref name="foweek">'''Futures and Options Week''': According to figures published in F&O Week [[10 October]] [[2005]]. See also [http://www.fow.com FOW Website].</ref> 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<sup>tm</sup> 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 contract|Futures]]/[[forward contract|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:
{| border="1" bordercolor="#ebebeb" cellspacing="0" cellpadding="4"
! rowspan="2" bgcolor="#EBEBEB" |UNDERLYING
! colspan="5" bgcolor="#EBEBEB" |CONTRACT TYPE
|-
! bgcolor="#E" '''Bold text'''|Exchange-traded futures
! bgcolor="#E"'''Bold text''' |Exchange-traded options
! bgcolor="#E" '''Bold text'''|OTC swap
! bgcolor="#EBEBEB" '''Bold text'''|OTC forward
! bgcolor="#EB" '''Bold text'''|OTC option
|-
! bgcolor="#EB'''Bold text'''" |[[Equity Index]]
| [[Dow Jones Industrial Average|DJIA]] Index future <BR /> [[NASDAQ]] Index future
| Option on [[Dow Jones Industrial Average|DJIA]] Index future <BR /> Option on [[NASDAQ]] Index future
| [[Equity swap]]
| Back-to-back
| n/a
|-
! bgcolor="#EBEBEB" |[[Money market]]
| Eurodollar future <BR /> Euribor future
| Option on Eurodollar future <BR /> Option on Euribor future
| [[Interest rate swap]]
| [[Forward rate agreement]]
| [[Interest rate cap and floor]] <BR /> [[Swaption]] <BR /> [[Basis swap]]
|-
! bgcolor="#EBEBEB" |[[Bond (finance)|Bond]]s
| Bond future
| Option on Bond future
| n/a
| [[Repurchase agreement]]
| [[Bond option]]
|-
! bgcolor="#EBEBEB" |Single [[Stock]]s
|[[Single-stock futures|Single-stock future]]
|Single-share option
|[[Equity swap]]
|Repurchase agreement
|[[Stock option]]<br />[[Warrant (finance)|Warrant]]<br />[[Turbo warrant]]
|-
! bgcolor="#EBEBEB" |Credit
| n/a
| n/a
|[[Credit default swap]]
| n/a
|[[Credit default option]]
|}
Other examples of underlying exchangeables are:
* [[Economic derivative]]s that pay off according to [[economic report]]s ([http://biz.yahoo.com/c/e.html]) as measured and reported by national statistical agencies
*[[Energy derivative]]'s that pay off according to a wide variety of indexed energy prices. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc.)
*[[Commodities]]
*[[Freight derivatives]]
*[[Inflation derivatives]]
*Insurance derivatives{{Fact|date=July 2008}}
*[[Weather derivatives]]
*[[Credit derivatives]]
*[[Property derivatives]]
==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 [[Default (finance)|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==
[[Image:Total world wealth vs total world derivatives 1998-2007.gif|thumb|450px|Total world derivatives from 1998-2007 compared to total world wealth in the year 2000{{cn}}]]
===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 (finance)|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:
:* The [[Nick Leeson]] affair in 1994.
:* {{POV|date=July 2008}}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.{{Fact|date=July 2008}} Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example: <ref>''Risk'' Magazine article on post-Katrina financing</ref>
:* 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 [[January 2008 Société Générale trading loss incident|loss of $7.2 Billion]] by [[Société Générale]] in January 2008 through mis-use of futures 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. 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.
* 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.
* 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]]{{Fact|date=January 2008}}. 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 game|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.{{Fact|date=March 2008}}
==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.
*[[Exchange-traded derivative contracts]]: Standardized derivative contracts (e.g. [[futures contract]]s and [[Option (finance)|options]]) that are transacted on an organized [[futures exchange]].
*[[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 security|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 (finance)|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.
*[[Total risk-based capital]]: The sum of [[Tier 1 capital|tier 1]] plus [[tier 2 capital]]. Tier 1 capital consists of [[common shareholders equity]], [[perpetual preferred shareholders equity]] with [[noncumulative dividends|non-cumulative dividends]], [[retained earnings]], and [[minority interest]]s in the equity accounts of [[consolidated subsidiaries]]. Tier 2 capital consists of [[subordinated debt]], intermediate-term [[preferred stock]], cumulative and long-term preferred stock, and a portion of a bank’s [[allowance for loan and lease losses]].
==Footnotes==
<references />
[http://www.risk.net/public/showPage.html?validate=0&page=risknet_login2&url=%2Fpublic%2FshowPage.html%3Fpage%3D325320 After the storm, ''Risk'' Magazine (2006), Navroz Patel]
==See also==
* [[FX Option]]
* [[Equity option]]
* [[Interest rate derivative]]
* [[DPC]], Derivative Products Company
==External links==
*[http://news.bbc.co.uk/1/hi/business/2817995.stm BBC NEWS | Business |Buffett warns on investment 'time bomb']
*[http://www.slate.com/id/2142158/?nav=tap3 Slate Magazine | Moneybox |Stocks Are So 20th Century By Daniel Gross] — A short introduction to Derivatives
*[http://nikhilnrohan.5u.com/reports.htm Finance Articles]
*[http://ria.thomson.com/estore/detail.aspx?id=tdvn&site=wiki Derivatives Financial Products Report from WG&L]
*[http://www.mayerbrown.com/london/article.asp?id=3648&nid=1575|title= PLC magazine, Derivatives Uncovered: swaps, futures and all that jazz, by Edmund Parker]
*[http://www.survivalblog.com/derivatives.html Derivatives--The Mystery Man Who'll Break the Global Bank at Monte Carlo]
*[http://www.moneyweek.com/file/19131/a-beginners-guide-to-derivatives.html A beginner's guide to derivatives], ''[[MoneyWeek]]'', September 29, 2006
*[http://articles.intelligentshare.com/2008/05/derivatives-overview-and-thoughts.html Derivatives Overview: What are they, Do they work, Uses, Abuses]
{{Derivatives market}}
[[Category:Derivatives]]
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