Derivative (finance)

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In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often called the "underlying".[1][2] Derivatives can be used for a number of purposes - including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard to trade assets or markets.[3]

Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as collateralized debt obligations, credit default swaps, and mortgage backed securities. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks or shares) and debt (i.e. bonds and mortgages).

Basics[edit]

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties.[4][5] The most common underlying assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm's capital structure, e.g. bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm's assets, but this is unusual outside of technical contexts.

From the economic point of view, financial derivatives are cash flows, that are conditionally stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately.[6] The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.[7]

There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded through specialized derivatives exchanges or other exchanges.[8]

Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[9] Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile.

Derivatives may broadly be categorized as "lock" or "option" products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate caps) provide the buyer the right, but not the obligation to enter the contract under the terms specified.

Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.[10]

Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission and those details are not finalized nor fully implemented as of late 2012.

Size of market[edit]

To give an idea of the size of the derivative market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.[11] However, these are "notional" values, and some economists say that this value greatly exaggerates the market value and the true credit risk faced by the parties involved. For example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion, the value of the market was estimated much lower, at $21 trillion. The credit risk equivalent of the derivative contracts was estimated at $3.3 trillion.[12]

Still, even these scaled down figures represent huge amounts of money. For perspective, the budget for total expenditure of the United States Government during 2012 was $3.5 trillion,[13] and the total current value of the US stock market is an estimated $23 trillion.[14] The world annual Gross Domestic Product is about $65 trillion.[15]

And for one type of derivative at least, Credit Default Swaps (CDS), for which the inherent risk is considered high, the higher, nominal value, remains relevant. It was this type of derivative that investment magnate Warren Buffet referred to in his famous 2002 speech in which he warned against "weapons of financial mass destruction." CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.[16]

Usage[edit]

Derivatives are used for the following:

  • Hedge 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[17][18]
  • Create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level)
  • Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g. weather derivatives)[19]
  • Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative[20]
  • Speculate and 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)
  • Switch asset allocations between different asset classes without disturbing the underlying assets, as part of transition management
  • Avoid paying taxes. For example, an equity swap allows an investor to receive steady payments, e.g. based on LIBOR rate, while avoiding paying capital gains tax and keeping the stock.

Mechanics and Valuation Basics[edit]

Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties. Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset (i.e. "in the money") or a liability (i.e. "out of the money") at different points throughout its life. Importantly, either party is therefore exposed to the credit quality of its counterparty and is interested in protecting itself in an event of default.

Option products have immediate value at the outset because they provide specified protection (intrinsic value) over a given time period (time value). One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections (intrinsic value) and one that extends for a year rather than six months (time value). Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value (i.e. if it is "in the money") or expire at no cost (other than to the initial premium) (i.e. if the option is "out of the money").

Hedging[edit]

Main article: Hedge (finance)

Derivatives allow risk related to the price 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 because of events unspecified by the contract, such as 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 counter-party risk.[21]

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 have) 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.[22]

Hedging also occurs when an individual or institution buys an asset (such as 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 can then 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 traders at the Chicago Board of Trade

Derivatives trading of this kind may serve the financial interests of certain particular businesses.[23] For example, a corporation borrows a large sum of money at a specific interest rate.[24] The interest rate on the loan reprices 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), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[25] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

Speculation and arbitrage[edit]

Derivatives can be used to acquire risk, rather than to 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 look 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 less.

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 regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[26]

Proportion Used for Hedging and Speculation[edit]

The true proportion of derivatives contracts used for hedging purposes is unknown [27] (and perhaps unknowable), but it appears to be relatively small.[28][29] Also, derivatives contracts account for only 3–6% of the median firms' total currency and interest rate exposure.[30] Nonetheless, we know that many firms' derivatives activities have at least some speculative component for a variety of reasons.[30]

Types[edit]

OTC and exchange-traded[edit]

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the 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, exotic options – and other exotic derivatives – 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 is difficult because trades can occur in private, without activity being visible on any exchange.

According to the Bank for International Settlements, who first surveyed OTC derivatives in 1995,[31] reported that the "gross market value, which represent the cost of replacing all open contracts at the prevailing market prices, ... increased by 74% since 2004, to $11 trillion at the end of June 2007 (BIS 2007:24)." [31] Positions in the OTC derivatives market increased to $516 trillion at the end of June 2007, 135% higher than the level recorded in 2004. the total outstanding notional amount is US$708 trillion (as of June 2011).[32] 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 counter-party. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counter-party relies on the other to perform.

Common derivative contract types[edit]

Some of the common variants of derivative contracts are as follows:

  1. Forwards: A tailored contract between two parties, where payment takes place at a specific time in the future at today's pre-determined price.
  2. Futures: 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; the forward contract is a non-standardized contract written by the parties themselves.
  3. 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. Options are of two types: call option and put option. The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right.
  4. Binary options are contracts that provide the owner with an all-or-nothing profit profile.
  5. Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options as well, known as Warrant (finance). These are generally traded over-the-counter.
  6. 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 exchange, stocks or other assets. Another term which is commonly associated to Swap is Swaption which is basically an option on the forward Swap. Similar to a Call and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand, in case of a receiver Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption on the other hand is an option to pay fixed and receive floating.
Swaps can basically be categorized into two types:
  • Interest rate swap: These basically necessitate swapping only interest associated cash flows in the same currency, between two parties.
  • Currency swap: In this kind of swapping, the cash flow between the two parties includes both principal and interest. Also, the money which is being swapped is in different currency for both parties.[35]

Some common examples of these derivatives are the following:

UNDERLYING CONTRACT TYPES
Exchange-traded futures Exchange-traded options OTC swap OTC forward OTC option
Equity DJIA Index future
Single-stock future
Option on DJIA Index future
Single-share option
Equity swap Back-to-back
Repurchase agreement
Stock option
Warrant
Turbo warrant
Interest rate 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
Bond option
Credit Bond future Option on Bond future Credit default swap
Total return swap
Repurchase agreement Credit default option
Foreign exchange Currency future Option on currency future Currency swap Currency forward Currency option
Commodity WTI crude oil futures Weather derivative Commodity swap Iron ore forward contract Gold option

Economic function of the derivative market[edit]

Some of the salient economic functions of the derivative market include:

  1. Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices.
  2. The derivatives market reallocates risk from the people who prefer risk aversion to the people who have an appetite for risk.
  3. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk.
  4. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment.
  5. Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.[36]

In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.[37]

Valuation[edit]

Total world derivatives from 1998 to 2007[38] compared to total world wealth in the year 2000[39]

Market and arbitrage-free prices[edit]

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[edit]

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[edit]

See List of finance topics# Derivatives pricing.

The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities.

However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding 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.

OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. Most of the model's results are input-dependent (meaning the final price depends heavily on how we derive the pricing inputs).[40] Therefore it is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal designate upfront (when signing the contract).

Criticisms[edit]

Derivatives are often subject to the following criticisms:

Hidden tail risk[edit]

According to Raghuram Rajan, a former chief economist of the International Monetary Fund (IMF), "... it may well be that the managers of these firms [investment funds] have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one — a phenomenon they term "phase lock-in." A hedged position can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected."[41]

Risks[edit]

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 following:

  • American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on credit default swaps (CDSs).[42] The United States Federal Reserve Bank announced the creation of a secured credit facility of up to US$85 billion, to prevent the company's collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners.[43]
  • The loss of US$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 loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.[44]
  • The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[45]
  • UBS AG, Switzerland's biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September 2011.[46]

This comes to a staggering $39.5 billion, the majority in the last decade after the Commodity Futures Modernization Act of 2000 was passed.

Counter party risk[edit]

Some derivatives (especially swaps) expose investors to counterparty risk, or risk arising from the other party in a financial transaction. 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[edit]

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' A potential problem with derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in the underlying capital and equities markets themselves. 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)

Financial Reform and Government Regulation[edit]

Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form to extend credit.[47] The strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency however, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.[47] Indeed, the use of derivatives to conceal credit risk from third parties while protecting derivative counterparties contributed to the financial crisis of 2008 in the United States.[47][48]

In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The department's antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."[49]

For legislators and committees responsible for financial reform related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative derivatives activities has been a nontrivial challenge. The distinction is critical because regulation should help to isolate and curtail speculation with derivatives, especially for "systemically significant" institutions whose default could be large enough to threaten the entire financial system. At the same time, the legislation should allow for responsible parties to hedge risk without unduly tying up working capital as collateral that firms may better employ elsewhere in their operations and investment.[50] In this regard, it is important to distinguish between financial (e.g. banks) and non-financial end-users of derivatives (e.g. real estate development companies) because these firms' derivatives usage is inherently different. More importantly, the reasonable collateral that secures these different counterparties can be very different. The distinction between these firms is not always straight forward (e.g. hedge funds or even some private equity firms do not neatly fit either category). Finally, even financial users must be differentiated, as 'large' banks may classified as "systemically significant" whose derivatives activities must be more tightly monitored and restricted than those of smaller, local and regional banks.

Over-the-counter dealing will be less common as the Dodd–Frank Wall Street Reform and Consumer Protection Act comes into effect. The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on derivatives. To implement Dodd-Frank, the CFTC developed new rules in at least 30 areas. The Commission determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a certain type of swap contract.

Nonetheless, the above and other challenges of the rule-making process have delayed full enactment of aspects of the legislation relating to derivatives. The challenges are further complicated by the necessity to orchestrate globalized financial reform among the nations that comprise the world's major financial markets, a primary responsibility of the Financial Stability Board whose progress is ongoing.[51]

In the U.S., by February 2012 the combined effort of the SEC and CFTC had produced over 70 proposed and final derivatives rules.[52] However, both of them had delayed adoption of a number of derivatives regulations because of the burden of other rulemaking, litigation and opposition to the rules, and many core definitions (such as the terms "swap," "security-based swap," "swap dealer," "security-based swap dealer," "major swap participant" and "major security-based swap participant") had still not been adopted.[52] SEC Chairman Mary Schapiro opined: "At the end of the day, it probably does not make sense to harmonize everything [between the SEC and CFTC rules] because some of these products are quite different and certainly the market structures are quite different."[53]

Country leaders at the 2009 G-20 Pittsburgh summit

In November 2012, the SEC and regulators from Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been agreed by leaders at the 2009 G-20 Pittsburgh summit in September 2009.[54] In December 2012, they released a joint statement to the effect that they recognized that the market is a global one and "firmly support the adoption and enforcement of robust and consistent standards in and across jurisdictions", with the goals of mitigating risk, improving transparency, protecting against market abuse, preventing regulatory gaps, reducing the potential for arbitrage opportunities, and fostering a level playing field for market participants.[54] They also agreed on the need to reduce regulatory uncertainty and provide market participants with sufficient clarity on laws and regulations by avoiding, to the extent possible, the application of conflicting rules to the same entities and transactions, and minimizing the application of inconsistent and duplicative rules.[54] At the same time, they noted that "complete harmonization – perfect alignment of rules across jurisdictions" would be difficult, because of jurisdictions' differences in law, policy, markets, implementation timing, and legislative and regulatory processes.[54]

On December 20, 2013 the CFTC provided information on its swaps regulation "comparability" determinations. The release addressed the CFTC's cross-border compliance exceptions. Specifically it addressed which entity level and in some cases transaction-level requirements in six jurisdictions (Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland) it found comparable to its own rules, thus permitting non-US swap dealers, major swap participants, and the foreign branches of US Swap Dealers and major swap participants in these jurisdictions to comply with local rules in lieu of Commission rules.[55]

Reporting[edit]

Mandatory reporting regulations are being finalized in a number of countries, such as Dodd Frank Act in the US, the European Market Infrastructure Regulations (EMIR) in Europe, as well as regulations in Hong Kong, Japan, Singapore, Canada, and other countries.[56] The OTC Derivatives Regulators Forum (ODRF), a group of over 40 world-wide regulators, provided trade repositories with a set of guidelines regarding data access to regulators, and the Financial Stability Board and CPSS IOSCO also made recommendations in with regard to reporting.[56]

DTCC, through its "Global Trade Repository" (GTR) service, manages global trade repositories for interest rates, and commodities, foreign exchange, credit, and equity derivatives.[56] It makes global trade reports to the CFTC in the U.S., and plans to do the same for ESMA in Europe and for regulators in Hong Kong, Japan, and Singapore.[56] It covers cleared and uncleared OTC derivatives products, whether or not a trade is electronically processed or bespoke.[56][57][58]

Glossary[edit]

  • 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.
  • Counterparty: The legal and financial term for the other party in a financial transaction.
  • 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 U.S. Federal Financial Institutions Examination Council 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.

Financial derivative trading companies[edit]

  • Alpari Group
  • Anyoption
  • Banc de Binary
  • Cantor Fitzgerald
  • CitiFXPro
  • City Index Group
  • CMC Markets
  • Currenex
  • DBF
  • EToro
  • ETX Capital
  • Finspreads
  • First Prudential Markets
  • FXCM
  • FXdirekt Bank
  • FXOpen
  • FXPro
  • Gain Capital
  • Henyep
  • Hirose Financial UK Ltd.
  • HXPM Gold
  • I-Access Investors
  • IDealing
  • IG Group
  • InstaForex
  • Interactive Brokers
  • InterTrader
  • Marex Spectron
  • MF Global
  • MRC Markets
  • Oanda Corporation
  • OptionsXpress
  • Pepperstone
  • Plus 500
  • Saxo Bank
  • Spread Co.
  • Spreadex
  • Sucden
  • TeleTrade
  • TFI Markets
  • Thinkorswim
  • Varen Gold
  • Wizetrade
  • Worldspreads
  • X-Trade Brokers
  • Zulu Trade

See also[edit]

References[edit]

  1. ^ Derivatives (Report). Office of the Comptroller of the Currency, U.S. Department of Treasury. http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/index-derivatives.html. Retrieved February 2013. "A derivative is a financial contract whose value is derived from the performance of some underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, or equity prices. Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof."
  2. ^ Derivative Definition Investopedia
  3. ^ Koehler, Christian. "The Relationship between the Complexity of Financial Derivatives and Systemic Risk". Working Paper: 10–11. 
  4. ^ Rubinstein, Mark (1999). Rubinstein on derivatives. Risk Books. ISBN 1-899332-53-7. 
  5. ^ Hull, John C. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. p. 1. 
  6. ^ Koehler, Christian. "The Relationship between the Complexity of Financial Derivatives and Systemic Risk". Working Paper: 10. 
  7. ^ Koehler, Christian. "The Relationship between the Complexity of Financial Derivatives and Systemic Risk". Working Paper: 10. 
  8. ^ http://chicagofed.org/webpages/publications/understanding_derivatives/index.cfm
  9. ^ Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan". The Financial Times. Retrieved October 23, 2010. 
  10. ^ http://chicagofed.org/webpages/publications/understanding_derivatives/index.cfm
  11. ^ "Clear and Present Danger; Centrally cleared derivatives.(clearing houses)". The Economist (Economist Newspaper Ltd.(subscription required)). 2012-04-12. Retrieved 2013-05-10. 
  12. ^ Liu, Qiao; Lejot, Paul (2013). "Debt, Derivatives and complex interactions". Finance in Asia: Institutions, Regulation and Policy. Douglas W. Arne. New York: Routledge. p. 343. ISBN 978-0-415-42319-9. 
  13. ^ "Summary Table1". The Budget and Economic Outlook: Fiscal Years 2013 to 2023. Congressional Budget Office. February 5, 2013. Retrieved March 15, 2013. 
  14. ^ "Swapping bad ideas: A big battle is unfolding over an even bigger market". The Economist (Economist Newspaper Ltd.). 2013-04-27. Retrieved 2013-05-10. 
  15. ^ "World GDP: In search of growth". The Economist (Economist Newspaper Ltd.). 2011-05-25. Retrieved 2013-05-10. 
  16. ^ Sheridan, Barrett (April 2008). "600,000,000,000,000?". Newsweek Inc. Retrieved 12 May 2013.  – via HighBeam (subscription required)
  17. ^ Khullar, Sanjeev (2009). "Using Derivatives to Create Alpha". In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientific. p. 105. ISBN 978-981-283-465-2. Retrieved September 14, 2011. 
  18. ^ Lemke and Lins, Soft Dollars and Other Trading Activities, §§2:47 - 2:54 (Thomson West, 2013-2014 ed.).
  19. ^ Don M. Chance; Robert Brooks (2010). "Advanced Derivatives and Strategies". Introduction to Derivatives and Risk Management (8th ed.). Mason, Ohio: Cengage Learning. pp. 483–515. ISBN 978-0-324-60120-6. Retrieved September 14, 2011. 
  20. ^ Shirreff, David (2004). "Derivatives and leverage". Dealing With Financial Risk. USA: The Economist. p. 23. ISBN 1-57660-162-5. Retrieved September 14, 2011. 
  21. ^ http://chicagofed.org/webpages/publications/understanding_derivatives/index.cfm
  22. ^ http://chicagofed.org/webpages/publications/understanding_derivatives/index.cfm
  23. ^ Peterson, Sam (2010). The Atlantic. "There's a Derivative in Your Cereal" http://www.theatlantic.com/business/archive/2010/07/theres-a-derivative-in-your-cereal/60582/
  24. ^ Chisolm, Derivatives Demystified (Wiley 2004)
  25. ^ Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.
  26. ^ News.BBC.co.uk, "How Leeson broke the bank – BBC Economy"
  27. ^ Chernenko, Sergey and Faulkender, Michael. The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps http://www.rhsmith.umd.edu/faculty/faulkender/swaps_JFQA_final.pdf
  28. ^ Knowledge@Wharton (2012). "The Changing Use of Derivatives: More Hedging, Less Speculation" http://knowledge.wharton.upenn.edu/article.cfm?articleid=709
  29. ^ Guay, Wayne R. and Kothari, S.P. (2001). "How Much do Firms Hedge with Derivatives?" http://papers.ssrn.com/sol3/papers.cfm?abstract_id=253036
  30. ^ a b Knowledge@Wharton (2006). "The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch?" http://knowledge.wharton.upenn.edu/article.cfm?articleid=1346
  31. ^ a b c d Ryan Stever; Christian Upper; Goetz von Peter (December 2007) (PDF). BIS Quarterly Review (Report). Bank for International Settlements. http://www.bis.org/publ/qtrpdf/r_qt0712.pdf.
  32. ^ BIS survey: The Bank for International Settlements (BIS) semi-annual OTC [derivatives market report, for end of June 2008, showed US$683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics.
  33. ^ Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
  34. ^ Futures and Options Week: According to figures published in F&O Week October 10, 2005. See also FOW Website.
  35. ^ "Financial Markets: A Beginner's Module". 
  36. ^ Michael Simkovic and Benjamin Kaminetzky (August 29, 2010). "Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution". Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011. Retrieved March 5, 2013. 
  37. ^ "Currency Derivatives: A Beginner's Module". 
  38. ^ "Bis.org". Bis.org. May 7, 2010. Retrieved August 29, 2010. 
  39. ^ "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006". Retrieved June 9, 2009. 
  40. ^ Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-2009. http://www.hedgefundsreview.com/hedge-funds-review/news/1560286/otc-pricing-deal-struck-fitch-solutions-pricing-partners
  41. ^ Raghuram G. Rajan (September 2006). "Has Financial Development Made the World Riskier?". European Financial Management (EUROPEAN FINANCIAL MANAGEMENT) 12 (4): 499–533. doi:10.1111/j.1468-036X.2006.00330.x. Retrieved January 17, 2012. 
  42. ^ Kelleher, James B. (September 18, 2008). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters". Reuters.com. Retrieved August 29, 2010. 
  43. ^ "Fed's $85 billion Loan Rescues Insurer"
  44. ^ Edwards, Franklin (1995). "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft". Derivatives Quarterly (Spring 1995): 8–17 
  45. ^ Whaley, Robert (2006). Derivatives: markets, valuation, and risk management. John Wiley and Sons. p. 506. ISBN 0-471-78632-2. 
  46. ^ "UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson". Businessweek. September 15, 2011. Retrieved March 5, 2013. 
  47. ^ a b c "Michael Simkovic, Secret Liens and the Financial Crisis of 2008.". American Bankruptcy Law Journal, Vol. 83, p. 253. 2009. Retrieved March 5, 2013. 
  48. ^ Michael Simkovic (January 11, 2011). "Bankruptcy Immunities, Transparency, and Capital Structure, Presentation at the World Bank". Ssrn.com. doi:10.2139/ssrn.1738539. Retrieved March 5, 2013. 
  49. ^ Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives", The New York Times, December 11, 2010 (December 12, 2010, p. A1 NY ed.). Retrieved December 12, 2010.
  50. ^ Zubrod, Luke (2011). The Atlantic. "Will the 'Cure' for Systemic Risk Kill the Economy?" http://www.theatlantic.com/business/archive/2011/06/will-the-cure-for-systemic-risk-kill-the-economy/240600/
  51. ^ Financial Stability Board (2012). "OTC Derivatives Market Reforms Third Progress Report on Implementation" June 15, 2012 http://www.financialstabilityboard.org/publications/r_120615.pdf
  52. ^ a b Proskauer Rose LLP. "SEC and CFTC oversight of derivatives: a status report". Lexology. Retrieved March 5, 2013. 
  53. ^ Younglai, Rachelle. "INTERVIEW – Not all SEC, CFTC rules must be harmonized". Reuters. Retrieved March 5, 2013. 
  54. ^ a b c d "Joint Press Statement of Leaders on Operating Principles and Areas of Exploration in the Regulation of the Cross-Border OTC Derivatives Market; 2012-251". Sec.gov. December 4, 2012. Retrieved March 5, 2013. 
  55. ^ "Derivatives: A first take on cross-border comparability". http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-cftc-derivatives.jhtml, December, 2013. 
  56. ^ a b c d e "DTCC's Global Trade Repository for OTC Derivatives ("GTR")". Dtcc.com. Retrieved March 5, 2013. 
  57. ^ "U.S. DTCC says barriers hinder full derivatives picture". Reuters. February 12, 2013. Retrieved March 5, 2013. 
  58. ^ Release, Press (August 5, 2010). "Derivatives trades will be tracked by Depository Trust". Futuresmag.com. Retrieved March 5, 2013. 

Further reading[edit]

External links[edit]