A derivative is a financial instrument that derives or gets it value from

some real good or stock. It is in its most basic form simply a contract
between two parties to exchange value based on the action of a real
good or service. Typically, the seller receives money in exchange for an
agreement to purchase or sell some good or service at some specified
future date.
The largest appeal of derivatives is that they offer some degree of
leverage. Leverage is a financial term that refers to the multiplication
that happens when a small amount of money is used to control an item
of much larger value. A mortgage is the most common form of
leverage. For a small amount of money and taking on the obligation of a
mortgage, a person gains control of a property of much larger value
than the small amount of money that has exchanged hands.
In finance, a derivative is a financial instrument (or, more simply, an
agreement between two parties) that has a value, based on the expected
future price movements of the asset to which it is linked—called the
underlying asset—[1] such as a share or a currency. There are many
kinds of derivatives, with the most common being swaps, futures, and
options. Derivatives are a form of alternative investment.
A derivative is not a stand-alone asset, since it has no value of its own.
However, more common types of derivatives have been traded on
markets before their expiration date as if they were assets. Among
the oldest of these are rice futures, which have been traded on the
Dojima Rice Exchange since the eighteenth century.[2]
Derivatives are usually broadly categorized by:
• the relationship between the underlying asset and the derivative
(e.g., forward, option, swap);
• the type of underlying asset (e.g., equity derivatives, foreign
exchange derivatives, interest rate derivatives, commodity derivatives
or credit derivatives);
• the market in which they trade (e.g., exchange-traded or over-the-
counter); and
• their pay-off profile.
Another arbitrary distinction is between:[3]
• vanilla derivatives (simple and more common); and
• exotic derivatives (more complicated and specialized).
Contents
[hide]
• 1 Uses
o 1.1 Hedging
o 1.2 Speculation and arbitrage
• 2 Types of derivatives
o 2.1 OTC and exchange-traded
o 2.2 Common derivative contract types
o 2.3 Examples
• 3 Valuation
o 3.1 Market and arbitrage-free prices
o 3.2 Determining the market price
o 3.3 Determining the arbitrage-free price
• 4 Criticism
o 4.1 Possible large losses
o 4.2 Counter-party risk
o 4.3 Large notional value
o 4.4 Leverage of an economy's debt
• 5 Benefits
• 6 Government regulation
• 7 Definitions
• 8 See also
• 9 References
• 10 Further reading
• 11 External links
[edit] Uses
Derivatives are used by investors to:
• provide leverage (or gearing), such that a small movement in the
underlying value can cause a large difference in the value of the
derivative;
• 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);
• 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;
• obtain exposure to the underlying where it is not possible to trade
in the underlying (e.g., weather derivatives);
• 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).
[edit] Hedging

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Derivatives can be considered as providing a form of insurance in

hedging, which is itself a technique that attempts to reduce risk.
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.
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.
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 can serve legitimate business purposes. For example, a
corporation borrows a large sum of money at a specific interest rate.[4]
The rate of interest on the loan resets 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.[5] 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.
[edit] Speculation and arbitrage
Derivatives can be used to acquire risk, rather than to insure or 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 low.
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.[6]
[edit] Types of derivatives
[edit] OTC and exchange-traded
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, and exotic options 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 are difficult because trades can occur in
private, without activity being visible on any exchange. According to
the Bank for International Settlements, the total outstanding notional
amount is US$684 trillion (as of June 2008).[7] 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 counter-party risk, like an ordinary
contract, since each counter-party relies on the other to perform.
• Exchange-traded derivative contracts (ETD) are those
derivatives instruments that are traded via specialized derivatives
exchanges or other exchanges. A derivatives exchange is a market
where individuals trade standardized contracts that have been defined
by the exchange.[8] 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[9] 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 totaled 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.
[edit] Common derivative contract types
There are three major classes of derivatives:
1. Futures/Forwards 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, whereas a forward contract is a non-
standardized contract written by the parties themselves.
2. 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.
3. 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, stocks or
other assets.
More complex derivatives can be created by combining the elements of
these basic types. For example, the holder of a swaption has the right,
but not the obligation, to enter into a swap on or before a specified
future date.
[edit] 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
Some common examples of these derivatives are:
CONTRACT TYPES
UNDERLYING
Exchange-traded
Exchange-traded
OTC swap
OTC forward OTC option
futures options
Option on DJIA Stock option
DJIA Index future Back-to-back
Equity future Equity swap Warrant
Single-stock future Repurchase agreement
Single-share option Turbo warrant
Interest rate cap and
Option on Eurodollar floor
Eurodollar future Forward rate
Interest rate future Interest rate swapSwaption
Euribor future agreement
Option on Euribor future Basis swap
Bond option
Credit default
Credit
Bond futureOption on Bond swap
future
RepurchaseCredit
agreement
default option
Total return swap
 Foreign
Currency future
Option on currency
Currency
future
Currency
swap forward
Currency option
exchange
Iron ore forward
Commodity
WTI crude oil
Weather
futuresderivatives
Commodity swapGold option
contract
Other examples of underlying exchangeables are:
• Property (mortgage) derivatives
• Economic derivatives that pay off according to economic reports[10]
as measured and reported by national statistical agencies
• Freight derivatives
• Inflation derivatives
• Weather derivatives
• Insurance derivatives[citation needed]
• Emissions derivatives[11]
[edit] Valuation

Total world derivatives from 1998-2007[12] compared to total world

wealth in the year 2000[13]
[edit] 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.
[edit] 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.
[edit] 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. 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.
And most of the model's results are input-dependant (meaning the final
price depends heavily on how we derive the pricing inputs).[14]
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).
[edit] Criticism
Derivatives are often subject to the following criticisms:
[edit] Possible large losses
See also: List of trading losses
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 need to recapitalize insurer American International
Group (AIG) with US$85 billion of debt provided by the US
federal government.[15] An AIG subsidiary had lost more than
US$18 billion over the preceding three quarters on Credit
Default Swaps (CDS) it had written.[16] It was reported that the
recapitalization was necessary because further losses were
foreseeable over the next few quarters.
• 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.[17]
• The loss of US$1.2 billion equivalent in equity
derivatives in 1995 by Barings Bank.[18]
[edit] Counter-party risk
Some 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 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.
[edit] 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 famed
investor Warren Buffett in Berkshire Hathaway's 2002 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)
[edit] 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, thereby 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)
[edit] Benefits
The use of derivatives also has its benefits:
• Derivatives facilitate the buying and selling of risk, and many
people[who?] consider this to 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.[citation needed]
[edit] Government regulation
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."[19]
[edit] 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.
[edit] See also

Book: Finance
Wikipedia Books are collections of articles that can be downloaded or
ordered in print.

• Dual currency deposit

• Forward contract
• FX Option
[edit] References
1. ^ McDonald, R.L. (2006) Derivatives markets. Boston:
Addison-Wesley
2. ^ Kaori Suzuki and David Turner (December 10, 2005).
"Sensitive politics over Japan's staple crop delays rice futures
plan". The Financial Times. http://www.ft.com/cms/s/0/d9f45d80-
6922-11da-bd30-0000779e2340.html. Retrieved October 23, 2010.
3. ^ Taylor, Francesca. (2007). Mastering Derivatives Markets.
Prentice Hall
4. ^ Chisolm, Derivatives Demystified (Wiley 2004)
5. ^ Chisolm, Derivatives Demystified (Wiley 2004) Notional
sum means there is no actual principal.
6. ^ News.BBC.co.uk, "How Leeson broke the bank - BBC
Economy"
7. ^ BIS survey: The Bank for International Settlements (BIS)
semi-annual OTC derivatives statistics report, for end of June
2008, shows US$683.7 billion 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.
8. ^ Hull, J.C. (2009). Options, futures, and other derivatives .
Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
9. ^ Futures and Options Week: According to figures published
in F&O Week 10 October 2005. See also FOW Website.
10. ^ "Biz.Yahoo.com". Biz.Yahoo.com. 2010-08-23.
http://biz.yahoo.com/c/e.html. Retrieved 2010-08-29.
11. ^ FOW.com, Emissions derivatives, 1 December 2005
12. ^ "Bis.org". Bis.org. 2010-05-07.
http://www.bis.org/statistics/derstats.htm. Retrieved 2010-08-29.
13. ^ "Launch of the WIDER study on The World Distribution of
Household Wealth: 5 December 2006".
http://www.wider.unu.edu/events/past-events/2006-
events/en_GB/05-12-2006/. Retrieved 9 June 2009.
14. ^ 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
15. ^ Derivatives Counter-party Risk: Lessons from AIG and the
Credit Crisis
16. ^ Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb
Goes Off on Wall Street" by James B. Kelleher of Reuters".
 Reuters.com.
http://www.reuters.com/article/newsOne/idUSN183715402008091
8. Retrieved 2010-08-29.
17. ^ Edwards, Franklin (1995), "Derivatives Can Be Hazardous
To Your Health: The Case of Metallgesellschaft", Derivatives
Quarterly (Spring 1995): 8–17,
http://www0.gsb.columbia.edu/faculty/fedwards/papers/Derivative
sCanBeHazardous.pdf
18. ^ Whaley, Robert (2006). Derivatives: markets, valuation,
and risk management. John Wiley and Sons. p. 506.
ISBN 0471786322. http://books.google.com/books?id=Hb7xXy-
wqiYC&printsec=frontcover&source=gbs_ge_summary_r&cad=0
#v=onepage&q&f=false.
19. ^ 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 2010-12-12.
[edit] Further reading
• Mehraj Mattoo (1997), Structured Derivatives: New Tools for
Investment Management A Handbook of Structuring, Pricing &
Investor Applications (Financial Times) Amazon listing
[edit] External links
• BBC News - Derivatives simple guide
• European Union proposals on derivatives regulation - 2008
onwards
• Derivatives in Africa
Retrieved from "http://en.wikipedia.org/wiki/Derivative_(finance)"