Derivative (finance)

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In finance, a derivative is a financial instrument that is derived from an underlying asset's value; rather than trade or exchange the asset itself, market participants enter into an agreement to exchange money, assets or some other value at some future date based on the underlying asset. Examples of assets could be anything from bars of gold, to a stock, or even an interest rate. A simple example is a futures contract: an agreement to exchange the underlying asset (or equivalent cash flows) at a future date. The exact terms of the derivative (the payments between the counterparties) depend on, but may or may not exactly correspond to, the behaviour or performance of the underlying asset.

There are many types of financial instruments that are grouped under the term derivatives, but options/futures and swaps are among the most common. Options are contracts where one party agrees to pay a fee to another for the right (but not the obligation) to buy something from or sell something to the other. For example, a person worried that the price of his Microsoft stock may go down before he plans to sell it may pay a fee to another person (the writer of a put option) who agrees to buy the stock from him at the strike price. The person in this example is using an option to manage the risk that his stock may go down, while the writer of the put option may be using the option as a way to benefit from the increase in the stock price and the fee income. In contrast to a put option, a call option gives the buyer of the option the right to purchase the underlying asset at a later date and at the specified strike price.

Later, contracts known as swaps appeared, where one party agrees to swap cash flows with another. For example, a business may have a fixed-rate loan, while another business may have a variable-rate loan; each of the businesses would prefer to have the other type of loan. Rather than cancel their existing loans (if this is possible, it may be expensive), the two businesses can achieve the same effect by agreeing to "swap" cash flows: the first pays the second based on a floating-rate loan, and the second pays the first based on a fixed-rate loan (in practice, the two will net out the amounts owing). By swapping the cash flow, each has "converted" one type of loan into another.

Derivatives can be based on different types of assets such as commodities, equities or bonds, interest rates, exchange rates, or indices (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 payoffs. The main use of derivatives is to either remove risk or take on risk depending if one were a hedger or a speculator. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. The main types of derivatives are futures, forwards, options and swaps. Derivatives are increasingly^{[citation needed]} being used to protect assets from drastic fluctuations and at the same time they are being re-engineered to cover all kinds of risk and with this the growth of the derivatives market continues.

Contents 1 Usages 1.1 Insurance and hedging 1.2 Speculation and arbitrage 2 Types of derivatives 2.1 OTC and exchange-traded 2.2 Common contract types 2.3 Examples 3 Portfolio 4 Cash flow 5 Valuation 5.1 Market and arbitrage-free prices 5.2 Determining the market price 5.3 Determining the arbitrage-free price 6 Controversy 7 Glossary 8 See also 8.1 Associations 8.2 Lists 9 Footnotes 10 External links 10.1 History 10.2 Associations 10.3 Risk 10.4 Articles 10.5 Books

Usages

Insurance and hedging

One use of derivatives is as a tool to transfer risk. For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads (or hedges) the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop that he will grow; the speculator will make a profit if the price rises, but also risks making a loss if the price falls.

It is not uncommon for farmers to walk away smiling when they have lost out in the derivatives market as the result of a hedge. In this case, they have profited from the real market from the sale of their crops. Contrary to popular belief, financial markets are not always a zero-sum game. This is an example of a situation where both parties in a financial markets transaction benefit.

Another example is the company General Electric. This company uses derivatives to "match funding" (GE webcast on derivatives) to mitigate interest rate and currency risk, and to lock in material costs. The program is strictly for forecasted and highly anticipated needs, and not a means to generate non-operating revenues. 90% of all derivatives revenue produced by derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable planning. On 2005-06 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003 (Revised 2004 10K (PDF, 787 KB)).

Speculation and arbitrage

Of course, 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.

Derivatives such as options, futures, or swaps, generally offer the greatest possible reward for betting on whether the price of an underlying asset will go up or down. For example, a person may believe that a drug company may find a cure for cancer in the next year. If the person bought the stock for $10.00, and it went to $20.00 after the cure was announced, the person would have made a 100% return. If he borrowed money to buy the stock (in US law the general maximum he could borrow would be $5.00 or half of the purchase price), he would have used only $5.00 dollars of his own money and thus made a 300% return. However, if he paid a 1 dollar option premium to buy the stock at 11 dollars, when it shot up to 20 dollars he could have received the difference (9 dollars) and thus make an 800% return.

Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position.

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 judgment 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 dollar 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 that 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 298 trillion (as of 2005)^[1].

• Exchange-traded derivatives 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), 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 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.
• Options, which are contracts that give a buyer the right (but not the obligation) to buy or sell an asset at a specified future date.
• Swaps, where the two parties agree to exchange cash flows.

Examples

Some common examples of these derivatives are:

UNDERLYING	CONTRACT TYPE
	Exchange traded futures	Exchange traded options	OTC swap	OTC forward	OTC option
Equity Index	DJIA Index future NASDAQ Index future	Option on DJIA Index future Option on NASDAQ Index future	Equity swap	Back-to-back	n/a
Money market	Eurodollar future Euribor future	Option on Eurodollar future Option on Euribor future	Interest rate swap	Forward rate agreement	Interest rate cap and floor Swaption Basis swap
Bonds	Bond future	Option on Bond future	n/a	Repurchase agreement	Bond option
Single Stocks	Single-stock future	Single-share option	Equity swap	Repurchase agreement	Stock option Warrant Turbo warrant
Foreign exchange	FX future	Option on FX future	Currency swap	FX forward	FX option
Credit	n/a	n/a	Credit default swap	n/a	Credit default option

Other examples of underlyings are:

• Economic derivatives that pay off according to economic reports ([1]) as measured and reported by national statistical agencies
• Energy derivatives 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
• Weather derivatives
• Credit derivatives
• Sports derivatives

Portfolio

An individual or a corporation should carefully weigh the risks of using derivatives since losses can be greater than the money put into these instruments. 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 or the theoretical price, meaning that no riskless 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 often complex, partly because of this there are often 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, but not always, 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.

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Controversy

The two types of derivatives have two distinct controversies associated with them. Options or futures can allow a person to pay only a premium to bet on the direction in an asset's price, and while this can often lead to 900% returns if the person is right, it would lead to a 100% loss (the premium paid) if the person is wrong. In fact, options or futures sold short may lead to great losses if the price of the derivative rises significantly. Besides the Nick Leeson affair, there have been several instances of massive losses in derivative markets. These events include the largest municipal bankruptcy in U.S. history, Orange County, CA in 1994 and the bankruptcy of Long-Term Capital Management.

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. Interestingly enough, Orange County was neither bankrupt nor insolvent at the time; however because of the strategy they employed they were 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 potential for these kinds of large losses have given derivatives a certain notoriety.

The other controversial risk of derivatives (primarily swaps) is known as counter party risk. For example, a person wanted a fixed interest rate loan for his business, 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 gone up a lot, it is possible that the first business may go bankrupt too because it can't afford to pay the higher variable rate. This chain reaction effect worries certain economists, who feel 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. Or banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However private agreements between two companies may have an unknown amount of due dilligance performed on each other, and this unknown has caused a lot of anxiety for many economists.

Because derivatives offer the possibility of large rewards, many individuals have a strong desire to invest in derivatives. Most financial planners caution against this, pointing out that an investor in derivatives often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor ([2]). One should keep in mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative.

Economists generally^{[citation needed]} believe that derivatives have a positive impact on the economic system by allowing the buying and selling of risk. 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. However, many economists^{[citation needed]} are worried that derivatives may cause an economic crisis at some point in the future.

There is the danger that someone could lose so much money that they would be unable to pay for their losses. This might cause chain reactions which could create an economic crisis. In 2002, legendary investor Warren Buffett commented in Berkshire Hathaway's annual report that he regarded them as 'financial weapons of mass destruction', an allusion to allegations being levelled at Iraq around that time. The problem with derivatives is that they control a huge notional amount of assets and this begins to affect 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.

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.

Thomas F. Siems a senior economist and policy adviser at the Federal Reserve Bank of Dallas wrote in a paper published by the Cato Institute titled 10 Myths About Financial Derivatives that fears about derivatives have proved unfounded. In this paper Siems explores 10 common misconceptions about financial derivatives. He argues that financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. And that if a firm wants to pursue value-enhancing investment opportunities, a feature of these prospect should be a risk-management strategy with derivatives as part of it. ^[3]

Glossary

From: Quarterly Derivatives Fact Sheet

• Bilateral Netting: A legally enforceable arrangement between a bank and a counterparty 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 which 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 contracts and 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 counterparties, without taking into account netting. This represents the maximum losses the bank’s counterparties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counterparties.

• Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counterparties, without taking into account netting. This represents the maximum losses a bank could incur if all its counterparties default and there is no netting of contracts, and the bank holds no counterparty 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.

• Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with noncumulative dividends, retained earnings, and minority interests 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.

See also

• Commodity markets
• Contract for difference
• Derivatives markets
• Financial engineering
• Financial mathematics
• Herfindahl index
• Financial Leverage
• Equity derivative

Associations

• International Swaps and Derivatives Association

Lists

• List of finance topics

Footnotes

1. ^ BIS survey: The Bank for International Settlements (BIS), in their semi-annual OTC derivatives market activity report from May 2005 that, at the end of December 2004, the total notional amounts outstanding of OTC derivatives was $248 trillion with a gross market value of $9.1 trillion. See also OTC derivatives markets activity in the second half of 2004.)
2. ^ Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website.
3. ^ Siems, Thomas F. (September 11, 1997). 10 Myths About Financial Derivatives. Policy Analysis. Cato Institute. Retrieved on 2006-11-04.

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