Derivative (finance)

Derivatives traders at the Chicago Board of Trade.

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 behavior 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 XYZ stock may go down before he plans to sell it may pay a fee to another person (the "writer" or seller of a put option) who agrees to buy the stock from him at the strike price. The buyer 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 to earn the fee income and may have the view that the stock will not go down. In contrast to a put option, a call option gives the buyer of the option the right to buy the underlying asset at a later date and at the specified price (this specified price is known as the option's strike).

Later, contracts known as interest rate 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" or "swapped" 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 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. It is, indeed, ironic that something set up to prevent risk will also allow parties to expose themselves to risk of exponential proportions.

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 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" 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 U.S. (in U.S. 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 Celent, as of May 2007, global technology spending on third party solutions for automating OTC derivative support in the post-trade/pre-settlement area was US$187.8 million. Celent anticipates a four-year annualized growth rate of 5.5% with total spending reaching US$232.5 million by 2011. According to the Bank for International Settlements, the total outstanding notional amount is USD 298 trillion (as of 2005) .) .

• 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 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 Derivative 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 holder 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
• Property 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 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 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.

Controversy

Derivatives are often subject to the following criticisms:

• The use of derivatives can result in large losses due to the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, including:

• the Nick Leeson affair,
• the bankruptcy of Long-Term Capital Management, and
• 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.

• Derivatives (especially swaps) expose investors to counterparty 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. This chain reaction effect worries certain economists, who posit 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; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for perforing due dilligence and risk analysis. This has been a cause for concern among many economists.

• Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. ([2]). Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it.

• Derivatives typically have a large notional value. As such, there is the danger that their use could result in a losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by legendary investor Warren Buffett in Berkshire Hathaway's annual report. Buffet stated that he regarded them as 'financial weapons of mass destruction'. The problem with derivatives is that they control a 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. Many economists are worried that derivatives may cause an economic crisis at some point in the future.

Nevertheless, the use of derivatives has its benefits:

• Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system. 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.
• 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.

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

External links

History

• A Brief History of Derivatives

Associations

*ISDA: Website of International Swaps and Derivatives Association

• OCC - Comptroller of the Currency, Administrator of National Banks
• Bank for International Settlements
• FIA: Futures Industry Association

Risk

• Quantnotes.com - introductory articles covering mathematical finance
• Riskglossary.com - an online glossary, encyclopedia, and resource locator

Articles

• BBC NEWS | Business |Buffett warns on investment 'time bomb'
• Derivatives Financier Henry Paulson Nominated To Head US Treasury: Will His Derivatives Bubble Be An Economic Tsunami? (this link doesn't work)
• A Brief History of Derivatives
• Slate Magazine | Moneybox |Stocks Are So 20th Century By Daniel Gross - A short introduction to Derivatives
• Finance Articles
• Derivatives Financial Products Report from WG&L

Books

• Miller, Merton Merton Miller on Derivatives Wiley, 1997 ISBN 0474183407
• Dick Bryan & Michael Rafferty, Capitalism with Derivatives: A Political Economy of Financial Derivatives, Capital and Class Palgrave Macmillan, 2005 ISBN-13: 978-1403936455