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Derivative (finance)

From Wikipedia, the free encyclopedia

A derivative is a financial instrument - or more simply, an agreement between two people ortwo parties - that has a value determined by the price of something else (called the underlying).[1]It is a financial contract with a value linked to the expected future price movements of the asset itis linked to - such as a share or a currency. There are many kinds of derivatives, with the mostnotable being swaps, futures, and options.

Referring to derivatives as stand-alone assets would be a misconception, since a derivative isincapable of having value of its own. However, some more commonplace derivatives, such asswaps, futures, and options, (which have a theoretical face value that can be calculated using

formulas, such asBlack-Scholes), have been traded on markets before their expiration date as ifthey were assets. Amongst the earlier derivatives, rice futures have been traded on theDojimaRice Exchangesince 1710.[

citation needed]

Derivatives are usually broadly categorized by the:

relationship between theunderlyingand the derivative (e.g.,forward,option,swap) type of underlying (e.g.,equity derivatives,foreign exchange derivatives,interest rate

derivatives, commodity derivatives orcredit derivatives) market in which they trade (e.g., exchange-traded orover-the-counter) pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded

optionality)

Uses

Derivatives are used by investors to

provideleverageor gearing, such that a small movement in the underlying value cancause a large difference in the value of the derivative

speculate and to make a profit if the value of the underlying asset moves the way theyexpect (e.g., moves in a given direction, stays in or out of a specified range, reaches acertain level)

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hedgeor mitigate risk in the underlying, by entering into a derivative contract whosevalue moves in the opposite direction to their underlying position and cancels part or allof it out

obtain exposure to underlying where it is not possible to trade in the underlying (e.g.,weather derivatives)

createoptionabilitywhere the value of the derivative is linked to a specific condition orevent (e.g., the underlying reaching a specific price level)

Hedging

Hedgingis a technique that attempts to reducerisk. In this respect, derivatives can be considereda form of insurance.

Derivatives allow risk about the price of the underlying asset to be transferred from one party to

another. For example, awheatfarmer and amillercould sign afutures contractto exchange aspecified amount of cash for a specified amount of wheat in the future. Both parties have reduceda future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availabilityof wheat. However, there is still the risk that no wheat will be available because of eventsunspecified by the contract, like the weather, or that one party will renege on the contract.Although a third party, called aclearing house, insures a futures contract, not all derivatives areinsured against counter-party risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk whenthey sign the futures contract: The farmer reduces the risk that the price of wheat will fall belowthe 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). Themiller, on the other hand, acquires the risk that the price of wheat will fall below the pricespecified in the contract (thereby paying more in the future than he otherwise would) and reducesthe 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 (risktaker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (like a commodity, a bondthat hascoupon payments, a stock that pays dividends, and so on) and sells it using a futurescontract. The individual or institution has access to the asset for a specified amount of time, andthen 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 thefuture selling price will deviate unexpectedly from the market's current assessment of the futurevalue of the asset.

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Derivatives traders at theChicago Board of Trade.

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

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, someindividuals and institutions will enter into a derivative contract to speculate on the value of theunderlying asset, betting that the party seeking insurance will be wrong about the future value ofthe underlying asset. Speculators will want to be able to buy an asset in the future at a low priceaccording to a derivative contract when the future market price is high, or to sell an asset in thefuture at a high price according to a derivative contract when the future market price is low.

Individuals and institutions may also look forarbitrageopportunities, as when the current buyingprice 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 whenNick Leeson, atrader atBarings Bank, made poor and unauthorized investments in futures contracts. Through acombination of poor judgment, lack of oversight by the bank's management and by regulators,

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and unfortunate events like theKobe earthquake, Leeson incurred a $1.3 billion loss thatbankrupted the centuries-old institution.[5]

Types of derivatives

OTC and exchange-traded

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

Over-the-counter(OTC) derivatives are contracts that are traded (and privatelynegotiated) directly between two parties, without going through an exchange or otherintermediary. Products such asswaps,forward rate agreements, andexotic optionsare

almost always traded in this way. The OTC derivative market is the largest market forderivatives, and is largely unregulated with respect to disclosure of information betweenthe parties, since the OTC market is made up of banks and other highly sophisticatedparties, such ashedge funds. Reporting of OTC amounts are difficult because trades canoccur in private, without activity being visible on any exchange. According to theBankfor International Settlements, the total outstanding notional amount is $684 trillion (as ofJune 2008).[6]Of this total notional amount, 67% areinterest rate contracts, 8% arecreditdefault 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 onan exchange, there is no central counter-party. Therefore, they are subject tocounter-partyrisk, like an ordinarycontract, since each counter-party relies on the other to

perform.

Exchange-traded derivative contracts(ETD) are those derivatives instruments that aretraded via specializedderivatives exchangesor other exchanges. A derivatives exchangeis a market where individuals trade standardized contracts that have been defined by theexchange.[7]A derivatives exchange acts as an intermediary to all related transactions,and takesInitial marginfrom both sides of the trade to act as a guarantee. The world'slargest[8]derivatives exchanges (by number of transactions) are theKorea Exchange(which listsKOSPIIndex Futures & Options),Eurex(which lists a wide range ofEuropean products such as interest rate & index products), andCME Group(made up ofthe 2007 merger of theChicago Mercantile Exchangeand theChicago Board of Trade

and the 2008 acquisition of theNew York Mercantile Exchange). According to BIS, thecombined turnover in the world's derivatives exchanges totaled USD 344 trillion duringQ4 2005. Some types of derivative instruments also may trade on traditional exchanges.For instance, hybrid instruments such as convertible bonds and/or convertible preferredmay be listed on stock or bond exchanges. Also,warrants(or "rights") may be listed onequity exchanges. Performance Rights, Cash xPRTs and various other instruments thatessentially consist of a complex set of options bundled into a simple package areroutinely listed on equity exchanges. Like other derivatives, these publicly traded

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e_derivativehttp://en.wikipedia.org/wiki/Derivative_%28finance%29#cite_note-afgh-5http://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Bank_for_International_Settlementshttp://en.wikipedia.org/wiki/Hedge_fundhttp://en.wikipedia.org/wiki/Exotic_optionhttp://en.wikipedia.org/wiki/Forward_rate_agreementhttp://en.wikipedia.org/wiki/Swap_%28finance%29http://en.wikipedia.org/wiki/Over-the-counter_%28finance%29http://en.wikipedia.org/wiki/Derivative_%28finance%29#cite_note-lee-4http://en.wikipedia.org/wiki/Kobe_earthquake

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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/Forwardsarecontractsto buy or sell anasseton or before a future date at a pricespecified today. A futures contract differs from a forward contract in that the futurescontract is a standardized contract written by aclearing housethat operates an exchangewhere the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

2. Optionsare contracts that give the owner the right, but not the obligation, to buy (in thecase of acall option) or sell (in the case of aput option) an asset. The price at which the

sale takes place is known as thestrike price, and is specified at the time the parties enterinto the option. The option contract also specifies a maturity date. In the case of aEuropean option, the owner has the right to require the sale to take place on (but notbefore) the maturity date; in the case of anAmerican option, the owner can require thesale to take place at any time up to the maturity date. If the owner of the contractexercises this right, the counter-party has the obligation to carry out the transaction.

3. Swapsare contracts to exchange cash (flows) on or before a specified future date basedon the underlying value of currencies/exchange rates, bonds/interest rates, commodities,stocks or other assets.

Examples

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

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

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