Derivative (finance)

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A derivative is a generic term for specific types of investments from which payoffs over time are derived from the performance of assets (such as commodities, shares or bonds), interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index of weather conditions). This performance can determine both the amount and the timing of the payoffs. 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.

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 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 the Bank for International Settlements, the total outstanding notional amount is USD 298 trillion (as of 2005)BIS survey: The Bank for International Settlements, in their semi-annual [OTC derivatives market activity] report from May 2005 that, at the end of December 2004, the total notional amounts outstanding of OTC derivatives was $248 trillion with a gross market value of $9.1 trillion. See also [OTC derivatives markets activity in the second half of 2004].).

• Exchange-traded derivatives are those derivatives products that are traded via Derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largestFutures and Options Week: According to figures published in F&O Week 10 October 2005. See also [FOW Website]. 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.

Common 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 the buyer 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	n/a	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 ([link]) 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)
• Freight derivative
• Insurance derivative
• Weather derivatives
• Credit derivatives

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 riskless 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 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.

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 making 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" ([GE webcast on derivatives]) 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.

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.

Pricing and information sharing

Futures markets are unusually efficient at gathering and processing information, and are often an extremely accurate predictor of events such as interest rate movements and oil price movements. DARPA also examined the idea of developing a futures market for world events, the Policy Analysis Market, with the idea of predicting terrorism amongst other things. The idea was halted due to political uproar, as it was pointed out that terrorists could trade on the market and directly profit from their activities.

Controversy

Besides the Nick Leeson affair, there have been several instances of massive losses in derivative markets. These events include the largest municipal bankruptcy in U.S. history, Orange County, CA in 1994, and the bankruptcy of Long-Term Capital Management.

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.

Because derivatives offer the possibility of large rewards, many individuals have the strong desire to invest in derivatives. Most financial planners caution against this, pointing out that an investor in derivatives often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor ([link]). One should keep in mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative.

Economists generally believe that derivatives have a positive impact on the economic system by allowing the buying and selling of risk. Since someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system. However, many economists are worried that derivatives may cause an economic crisis at some point in the future.

There is the danger, however, that someone would lose so much money that they would be unable to pay for their losses. This might cause chain reactions which could create an economic crisis. In 2002, legendary investor Warren Buffett commented in Berkshire Hathaway's annual report that he regarded them as 'financial weapons of mass destruction', an allusion to the phrase 'weapons of mass destruction' relating to physical weapons which had wide currency at the time.

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.

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

Associations

• International Swaps and Derivatives Association

Lists

• List of finance topics

Footnotes

External links

History

• [A Brief History of Derivatives]

Associations

• [FIA: Futures Industry Association]
• [ISDA: Website of International Swaps and Derivatives Association]
• [OCC - Comptroller of the Currency, Administrator of National Banks]
• [Bank for International Settlements]

Risk

• [Quantnotes.com] - introductory articles covering mathematical finance
• [Riskglossary.com] - an online glossary, encyclopedia, and resource locator
• [Riskworx.com] - discussion of the application and theory of derivatives

Software

• [Orc Software] - Software for derivatives trading
• [Derivatives One] - Derivatives valuation software
• [GL Trade] - Software for derivatives trading

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?]
• [A Brief History of Derivatives]
• [Slate Magazine | Moneybox | Stocks Are So 20th Century By Daniel Gross] - A short introduction to Derivatives

Forums

• [wilmott.com] - Popular forum for practitioners, researchers and students in quantitative finance. Also research articles and jobs.

• [DeriBoard.com] - The discussion board for specialists, researchers and students of financial derivatives. (Incl. Options Calculator)

• [derivativesportal.org] - The portal has a forum and lists all relevant studies and papers written about financial derivatives and risk management and is funded by the IMC Foundation for derivatves, a not for profit organisation promoting the knowledge of derivatives in the academic world and financial industry.
• [happybroker.blogspot.com] - A blog about derivatives

• [QUANTster: The Quantitative Finance Job Market Daily] THE source for Quants in North America.

 

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