A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency (money) for a commodity (say, an apple). The exchange is complete, both parties have something tangible. If the purchaser had called the store and asked for the apple to be held for one hour while the purchaser drives to the store, and the seller agrees, then a derivative has been created. The agreement (derivative) is derived from a proposed exchange (trade money for apple in one hour, not now).

In financial terms, a derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying).^[1] It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is near endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying.

A common misconception is to refer to derivatives as assets. This is erroneous, since a derivative is incapable of having value of its own. However, some more commonplace derivatives, such as swaps, futures, and options, which have a theoretical face value that can be calculated using formulas, such as Black-Scholes The Black–Scholes model is a mathematical description of financial markets and derivative investment instruments. The model develops partial differential equations whose solution, the Black–Scholes formula, is widely used in the pricing of European-style options, are frequently traded on open markets before their expiration date as if they were assets.

Derivatives are usually broadly categorized by the:

• relationship between the underlying In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying. There must be an independent way to observe this value to avoid conflicts of interest and the derivative (e.g., forward A forward contract or simply a forward is a non-standardized agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the, option In finance, an option is a type of financial instrument classed as derivatives because they derive their value from an underlying asset. An option gives its holder the right, but not the obligation, to buy or to sell some asset on or before the option's expiration at an agreed price, the strike price, swap In finance, a swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. Specifically, the two counterparties agree to exchange one stream of cash flows against)
• type of underlying (e.g., equity derivatives In finance equity derivatives is a class of derivatives which value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded, foreign exchange derivatives A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. For detail see:, interest rate derivatives An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate, commodity derivatives or credit derivatives In finance, a credit derivative is a derivative whose value is derived from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of)
• market in which they trade (e.g., exchange-traded or over-the-counter Over-the-counter or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges)
• pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)

^[2]Another arbitrary distinction is between:

• vanilla derivatives (simple and more common) and
• exotic derivatives (more complicated and specialized)

There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

Derivatives are used by investors to

• provide leverage In finance, leverage refers to the use of debt to supplement investment. Companies usually leverage to increase returns to stock, as this practice can maximize gains (and losses). The easy but high-risk increases in stock prices due to levering at banks in the United States have been blamed for the unusually high rate of pay for top executives or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative
• speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)
• hedge In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
• obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
• create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)

Uses

Hedging

Hedging In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, is a technique that attempts to reduce risk Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost or by failing to attain some. In this respect, derivatives can be considered a form of insurance.

Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. For example, a wheat Wheat is a grass, originally from the Fertile Crescent region of the Near East, but now cultivated worldwide. In 2007 world production of wheat was 607 million tons, making it the third most-produced cereal after maize (784 million tons) and rice (651 million tons). Globally, wheat is the leading source of vegetable protein in human food, having a farmer and a miller A miller usually refers to a person who operates a mill, a machine to grind a cereal crop to make flour could sign a futures contract In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They 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 because of events unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. These transactions may be executed on a futures exchange or securities exchange, as well as "off-exchange" in the Over-The-Counter markets. The clearing of the OTC transactions, insures a futures contract, not all derivatives are insured against counter-party 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 counter-party 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 The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a percentage of the face value of the bond. It is the interest rate that a bond issuer will pay to a bondholder, 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.

Derivatives serve a legitimate business purpose. For example, a corporation borrows a large sum of money at a specific interest rate.^[3] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA). A forward rate agreement is a contract to pay a fixed rate of interest six months after purchases on a notional sum of money.^[4] If the interest rate after six months is above the contract rate, the seller pays the difference to the corporation, or FRA buyer. If the rate is lower, the corporation would pay the difference to the seller. The purchase of the FRA would serve to reduce the uncertainty concerning the rate increase and stabilize earnings.

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 In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow 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 1995 was a common year that started on a Sunday of the Gregorian calendar. The year 1995 was the 1995th year in the Anno Domini/Common Era and the 6th year of the 1990s when Nick Leeson Nicholas "Nick" Leeson is a former derivatives broker whose fraudulent, unauthorized speculative trading caused the collapse of Barings Bank, the United Kingdom's oldest investment bank, for which he was sent to prison. Since leaving prison in 1999 he has become the CEO of Irish football club Galway United and an after dinner speaker, a trader at Barings Bank Barings Bank was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost £827 million ($1.3 billion) speculating—primarily—on futures contracts, 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 The Great Hanshin earthquake , or Kobe earthquake as it is more commonly known outside Japan, was an earthquake that occurred on Tuesday, January 17, 1995, at 05:46 JST in the southern part of Hyōgo Prefecture, Japan. It measured 6.8 on the Moment magnitude scale (USGS), and Mj7.3 on the revised (7.2 on the old) JMA magnitude scale. The tremors, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.^[5]

Types of derivatives

OTC and exchange-traded

In broad terms, there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in the market:

• Over-the-counter Over-the-counter or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges (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 In finance, a swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. Specifically, the two counterparties agree to exchange one stream of cash flows against, forward rate agreements, and exotic options In finance, an exotic option is a derivative which has features making it more complex than commonly traded products . These products are usually traded over-the-counter (OTC), or are embedded in structured notes 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 A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and. 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 Bank for International Settlements is an international organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government. The BIS carries out its work through subcommittees, the secretariats it hosts, and through its, the total outstanding notional amount is $684 trillion (as of June 2008).^[6] Of this total notional amount, 67% are interest rate contracts An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate, 8% are credit default swaps (CDS) A credit default swap is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default, 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 counter-party. Therefore, they are subject to counter-party Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Another term for credit risk is default risk risk, like an ordinary contract In law, a contract is an agreement between two or more parties which, if it contains the elements of a valid legal agreement, is enforceable by law or by binding arbitration. A legally enforceable contract is an exchange of promises with specific legal remedies for breach. These can include compensatory remedy, whereby the defaulting party is, since each counter-party relies on the other to perform.

• Exchange-traded derivative contracts Exchange-traded derivative contracts are standardized derivative contracts that are transacted on an organized futures exchange (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges A futures exchange or derivatives exchange is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange.^[7] A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin In finance, a margin is a collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty . This risk can arise if the holder has done any of the following: from both sides of the trade to act as a guarantee. The world's largest^[8] derivatives exchanges (by number of transactions) are the Korea Exchange Korea Exchange was created through the integration of the three existing Korean spot & futures exchanges (Korea Stock Exchange, Korea Futures Exchange and KOSDAQ) under the Korea Stock & Futures Exchange Act.The securities and futures markets of former exchanges are now operated as the business divisions of the KRX: the Stock Market (which lists KOSPI The Korea Composite Stock Price Index or KOSPI is the index of all common stocks traded on the Stock Market Division—previously, Korea Stock Exchange—of the Korea Exchange. It's the representative stock market index of South Korea, like the Dow Jones Industrial Average or S&P 500 in the U.S Index Futures & Options), Eurex Eurex is the world's largest futures and options exchange, providing European benchmark derivatives featuring open and low-cost electronic access globally. Its electronic trading and clearing platform offers a broad range of products, and amongst others operates the most liquid fixed income markets. Eurex was established in 1998 with the merger of (which lists a wide range of European products such as interest rate & index products), and CME Group CME Group Inc. is the world’s largest futures exchange.[citation needed] CME Group was created July 12, 2007 from the merger between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT).[citation needed] (made up of the 2007 merger of the Chicago Mercantile Exchange The Chicago Mercantile Exchange (often called "the Chicago Merc," or "the Merc") is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization. The exchange demutualized in November 2000, went and the Chicago Board of Trade The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million contracts. On 12 July 2007, the CBOT merged with the and the 2008 acquisition of the New York Mercantile Exchange The New York Mercantile Exchange is the world's largest physical commodity futures exchange, located in New York City. Its two principal divisions are the New York Mercantile Exchange and Commodity Exchange, Inc (COMEX) which were once separate but are now merged. The parent company of the New York Mercantile Exchange, Inc., NYMEX Holdings, Inc). According to BIS, the combined turnover in the world's derivatives exchanges totaled 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 In finance, a warrant is a security that entitles the holder to buy stock of the issuing company at a specified price, which can be higher or lower than the stock price at time of issue (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 In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They/Forwards A forward contract or simply a forward is a non-standardized agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the are contracts In law, a contract is an agreement between two or more parties which, if it contains the elements of a valid legal agreement, is enforceable by law or by binding arbitration. That is to say, a contract is an exchange of promises with specific legal remedies for breach. These can include Compensatory remedy, whereby the defaulting party is required to buy or sell an asset In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset. Simplistically stated, assets represent ownership of value that can be converted into cash . The balance sheet of a firm 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 A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. These transactions may be executed on a futures exchange or securities exchange, as well as "off-exchange" in the Over-The-Counter markets. The clearing of the OTC transactions that operates an exchange where the contract can be bought and sold, whereas 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 counter-party 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

The overall derivatives market has five major classes of underlying asset:

• interest rate derivatives (the largest)
• foreign exchange derivatives
• credit derivatives
• equity derivatives
• commodity derivatives

Some common examples of these derivatives are:

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives
• Economic derivatives that pay off according to economic reports^[9] as measured and reported by national statistical agencies
• Freight derivatives
• Inflation derivatives
• Weather derivatives
• Insurance derivatives^{[citation needed]}
• Emissions derivatives^[10]

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.

Criticisms

Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses because of the use of leverage, or borrowing. 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, such as:

• The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the US federal government.^[13] An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written.^[14] It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters.
• The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.
• The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
• The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
• 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.^{[citation needed]} Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example:^[15]
• The Nick Leeson affair in 1994.

Members of President Clinton's Working Group on Financial Markets: Larry Summers, Alan Greenspan, Arthur Levitt, and Robert Rubin, have been criticized for torpedoing an effort to regulate the derivatives' markets, and thereby helping to bring down the financial markets in Fall 2008. President George W. Bush has also been criticized because he was President for 8 years preceding the 2008 meltdown and did nothing to regulate derivative trading. Bush has stated that deregulation was one of the core tenets of his political philosophy.

Counter-party risk

Some 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 counter-party risk. 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 that 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.

Large notional value

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 famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them '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. (See Berkshire Hathaway Annual Report for 2002)

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby 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. (See Berkshire Hathaway Annual Report for 2002)

Benefits

The use of derivatives also has its benefits:

• Derivatives facilitate the buying and selling of risk, and many people^[who?] consider this to have a positive impact on the economic system. 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.^{[citation needed]}

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 swaps, credit linked 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 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.
• 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 non-cumulative 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

• Credit risk
• Dual currency deposit
• FX Option
• Interest rate derivative
• Forward contract
• Futures contract
• Option (finance)

Notes & references

1. ^ McDonald, R.L. (2006) Derivatives markets. Boston: Addison-Wesley
2. ^ Taylor, Francesca. (2007). Mastering Derivatives Markets. Prentice Hall
3. ^ Chisolm, Derivatives Demystified (Wiley 2004)
4. ^ Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.
5. ^ News.BBC.co.uk, "How Leeson broke the bank - BBC Economy"
6. ^ BIS survey: The Bank for International Settlements (BIS) semi-annual 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.
7. ^ Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
8. ^ Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website.
9. ^ Biz.Yahoo.com
10. ^ FOW.com, Emissions derivatives, 1 December 2005
11. ^ Bis.org
12. ^ "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006". http://www.wider.unu.edu/events/past-events/2006-events/en_GB/05-12-2006/. Retrieved 9 June 2009.
13. ^ Derivatives Counter-party Risk: Lessons from AIG and the Credit Crisis
14. ^ "Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters
15. ^ Risk Magazine article on post-Katrina financing

Further reading

• Weinberg, Ari, "The Great Derivatives Smackdown", Forbes magazine, May 9, 2003.

External links

• Article describing the $190,000 derivatives burden per person
• PBS (WGBH, Boston), "The Warning", Frontline TV public affairs program, October 20, 2009. "At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008."

Categories: Derivatives | Financial terminology

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• Beta (Finance): Encyclopedia
• Financial Ratio: Encyclopedia
• Short (Finance): Encyclopedia
• Margin (Finance): Encyclopedia
• Outline of Finance: Encyclopedia

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