Derivative (finance)

Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, 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 pay-offs. Credit derivatives have become an increasingly large part of the derivative market.

Uses

Hedging

Derivatives allow risk to be transfer about the value of the 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 wheat miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. (But a third party, called a clearing house, usually insures the validity of a futures contract.)

From another perspective, we can say that 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 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 counterparty is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys buys an asset (like 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, 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 traders at the Chicago Board of Trade.

Speculation and arbitrage

Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.

In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility 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 judgement on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion 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 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 derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements, the total outstanding national amount is $596 trillion (as of December 2007). Of this total national amount, 66% are interest rate contracts, 10% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. OTC derivatives are largely subject to counterparty risk, as the validity of a contract depends on the counterparty's solvency and ability to honor its obligations.

• Exchange-traded derivatives (ETD) 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), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). 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 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/Forward are contracts to buy or sell an asset on or before a future date at a price specified today.
2. Options are contracts that give the owner the right, but not the obligation, to buy or sell an asset on or before a future date at a price specified today. If the owner of the contract exercises this right, the counterparty 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 of currencies, bonds, interest rates, commodities, stocks or other assets.

Examples

Some common examples of these derivatives are:

UNDERLYING	CONTRACT TYPES
	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
Credit	n/a	n/a	Credit default swap	n/a	Credit default option

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives
• 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

Portfolio

It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. They simply derive their values from assets such as bonds, equities, currencies, etc. and are used to either hedge those assets or improve the returns on those assets.

Cash flow

The payments between the parties may be determined by:

• the price of some other, independently traded asset in the future (e.g., a common stock);
• the level of an independently determined index (e.g., a stock market index or heating-degree-days);
• the occurrence of some well-specified event (e.g., a company 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

Total world derivatives from 1998-2007 compared to total world wealth in the year 2000

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

See also: List of trading losses

The use of derivatives can result in large losses due to 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. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written. 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 bankruptcy of Long-Term Capital Management in 2000.
• 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. Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example:
• The Nick Leeson affair in 1994

Counter-party risk

Derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate.

Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

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

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 legendary investor Warren Buffett in Berkshire Hathaway's 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 and curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)

Benefits

Nevertheless, the use of derivatives also 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.

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

• FX Option
• Equity option
• Interest rate derivative
• DPC, Derivative Products Company

External links

• BBC NEWS | Business |Buffett warns on investment 'time bomb'
• Slate Magazine | Moneybox |Stocks Are So 20th Century By Daniel Gross — A short introduction to Derivatives
• Finance Articles
• Derivatives--The Mystery Man Who'll Break the Global Bank at Monte Carlo
• A beginner's guide to derivatives, MoneyWeek, September 29, 2006
• Derivatives Overview: What are they, Do they work, Uses, Abuses
• [2] Hedge funds and the dangers of reckless complacency