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In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption (economics) ...
, a derivative is a
contract A contract is a legally enforceable agreement between two or more Party (law), parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, Service (economics), ser ...
that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...
,
index Index (or its plural form indices) may refer to: Arts, entertainment, and media Fictional entities * Index (''A Certain Magical Index''), a character in the light novel series ''A Certain Magical Index'' * The Index, an item on a Halo megastru ...
, or
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements ( hedging), increasing exposure to price movements for
speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline i ...
, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic
collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured finance, structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing Mortgage-backed se ...
s and
credit default swap A credit default swap (CDS) is a Swap (finance), financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt Default (finance), default (by the debtor) or other credit event. That is, the seller of the ...
s. Most derivatives are traded
over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...
(off-exchange) or on an exchange such as the
Chicago Mercantile Exchange The Chicago Mercantile Exchange (CME) (often called "the Chicago Merc", or "the Merc") is a global derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board, an a ...
, while most
insurance Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to Hedge ( ...
contracts have developed into a separate industry. In the
United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...
, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being equity (i.e., stocks or shares) and
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The de ...
(i.e., bonds and
mortgages A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners ...
). The oldest example of a derivative in history, attested to by
Aristotle Aristotle (; grc-gre, Ἀριστοτέλης ''Aristotélēs'', ; 384–322 BC) was a Greek philosopher and polymath during the Classical Greece, Classical period in Ancient Greece. Taught by Plato, he was the founder of the Peripatet ...
, is thought to be a contract transaction of
olive The olive, botanical name ''Olea europaea'', meaning 'European olive' in Latin, is a species of small tree or shrub in the family (biology), family Oleaceae, found traditionally in the Mediterranean Basin. When in shrub form, it is known as '' ...
s, entered into by ancient Greek philosopher
Thales Thales of Miletus ( ; grc-gre, wikt:Θαλῆς, Θαλῆς; ) was a Greeks, Greek Greek Mathematics, mathematician, astronomer, statesman, and Pre-Socratic philosophy, pre-Socratic philosopher from Miletus in Ionia, Asia Minor. He was one of ...
, who made a profit in the exchange. Bucket shops, outlawed in 1936, are a more recent historical example.


Basics

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the
notional amount The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...
) under which payments are to be made between the parties. The
assets In financial accounting Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of Financial statement audit, financial ...
include
commodities In economics, a commodity is an economic goods, good, usually a resource, that has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to who Production ...
,
stock In finance, stock (also capital stock) consists of all the Share (finance), shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which owners ...
s, bonds,
interest rates An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
and
currencies A currency, "in circulation", from la, Wikt:currens, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or currency in circulation, circulation as a medium of exchange, for example ba ...
, but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm's
capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as Financial_capital, capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is ...
, e.g., bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm's assets, but this is unusual outside of technical contexts. From the economic point of view, financial derivatives are cash flows that are conditioned
stochastic Stochastic (, ) refers to the property of being well described by a random probability distribution. Although stochasticity and randomness are distinct in that the former refers to a modeling approach and the latter refers to phenomena themsel ...
ally and discounted to present value. The
market risk Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most ...
inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the
market value Market value or OMV (Open Market Valuation) is the price at which an asset would trade in a Market (economics), competitive auction setting. Market value is often used interchangeably with ''open market value'', ''fair value'' or ''fair market va ...
of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows derivative designers to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation. There are two groups of derivative contracts: the privately traded
over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...
(OTC) derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded through specialized
derivatives exchange A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivative (finance), derivatives contracts to buy or sell specific quantitie ...
s or other exchanges. Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives,
foreign exchange derivative A foreign exchange derivative is a financial derivative In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, Index fund, index, or interest rat ...
s,
interest rate derivative In finance, an interest rate derivative (IRD) is a derivative (finance), derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There a ...
s, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or
over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...
); and their pay-off profile. Derivatives may broadly be categorized as "lock" or "option" products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate swaps) provide the buyer the right, but not the obligation to enter the contract under the terms specified. Derivatives can be used either for risk management (i.e. to "
hedge A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoini ...
" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders. Along with many other financial products and services, derivatives reform is an element of the
Dodd–Frank Wall Street Reform and Consumer Protection Act The Dodd–Frank Wall Street Reform and Consumer Protection Act, commonly referred to as Dodd–Frank, is a United States federal law that was enacted on July 21, 2010. The law overhauled financial regulation in the aftermath of the Great Recessi ...
of 2010. The Act delegated many rule-making details of regulatory oversight to the
Commodity Futures Trading Commission The Commodity Futures Trading Commission (CFTC) is an Independent agencies of the United States government, independent agency of the US government created in 1974 that regulates the U.S. derivatives markets, which includes futures contract, futu ...
(CFTC) and those details are not finalized nor fully implemented as of late 2012.


Size of market

To give an idea of the size of the derivative market, ''
The Economist ''The Economist'' is a British weekly newspaper printed in Paper size#Demitab, demitab format and Electronic publishing, published digitally. It focuses on current affairs, international business, politics, technology, and culture. Based in Lo ...
'' has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion. For the fourth quarter 2017 the European Securities Market Authority estimated the size of European
derivatives market The derivatives market is the financial market A financial market is a market (economics), market in which people trade financial Security (finance), securities and derivative (finance), derivatives at low transaction costs. Some of the s ...
at a size of €660 trillion with 74 million outstanding contracts. However, these are "notional" values, and some economists say that these aggregated values greatly exaggerate the market value and the true credit risk faced by the parties involved. For example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion, the value of the market was estimated to be much lower, at $21 trillion. The credit-risk equivalent of the derivative contracts was estimated at $3.3 trillion. Still, even these scaled-down figures represent huge amounts of money. For perspective, the budget for total expenditure of the United States government during 2012 was $3.5 trillion, and the total current value of the U.S. stock market is an estimated $23 trillion. Meanwhile, the world annual Gross Domestic Product is about $65 trillion. At least for one type of derivative, Credit Default Swaps (CDS), for which the inherent risk is considered high , the higher, nominal value remains relevant. It was this type of derivative that investment magnate
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net ...
referred to in his famous 2002 speech in which he warned against "financial weapons of mass destruction". CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.


Usage

Derivatives are used for the following: *
Hedge A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoini ...
or to mitigate risk in the underlying, by entering into a derivative
contract A contract is a legally enforceable agreement between two or more Party (law), parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, Service (economics), ser ...
whose value moves in the opposite direction to their underlying position and cancels part or all of it out * 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) * Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives) * 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) * Switch
asset allocation Asset allocation is the implementation of an investment strategy that attempts to balance risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with re ...
s between different
asset classes In finance, an asset class is a group of financial instrument Financial instruments are monetary Contract, contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership in ...
without disturbing the underlying assets, as part of transition management * Avoid paying taxes. For example, an equity swap allows an investor to receive steady payments, e.g. based on
SONIA Sonia, Sonja or Sonya, a name of Greek origin meaning wisdom, may refer to: People * Sonia (name), a feminine given name (lists people named, Sonia, Sonja and Sonya) :* Sonia (actress), Indian film actress in Malayalam and Tamil films :* Sonia ...
rate, while avoiding paying
capital gains tax A capital gains tax (CGT) is the tax on profits realized on the sale of a non-inventory asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible ...
and keeping the stock. * For arbitraging purpose, allowing a riskless profit by simultaneously entering into transactions into two or more markets.


Mechanics and valuation

Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties. Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset (i.e., " in the money") or a liability (i.e., " out of the money") at different points throughout its life. Importantly, either party is therefore exposed to the credit quality of its
counterparty A counterparty (sometimes contraparty) is a Juristic person, legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the ...
and is interested in protecting itself in an event of default. Option products have immediate value at the outset because they provide specified protection ( intrinsic value) over a given time period ( time value). One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections (intrinsic value) and one that extends for a year rather than six months (time value). Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value (i.e., if it is "in the money") or expire at no cost (other than to the initial premium) (i.e., if the option is "out of the money").


Hedging

Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a
wheat Wheat is a Poaceae, grass widely Agriculture, cultivated for its seed, a cereal grain that is a worldwide staple food. The Taxonomy of wheat, many species of wheat together make up the genus ''Triticum'' ; the most widely grown is common wheat ...
farmer and a
miller A miller is a person who operates a Gristmill, mill, a machine to grind a grain (for example corn or wheat) to make flour. Mill (grinding), Milling is among the oldest of human occupations. "Miller", "Milne" and other variants are common surname ...
could sign a
futures contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
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 trading of this kind may serve the financial interests of certain particular businesses. For example, a corporation borrows a large sum of money at a specific interest rate. The interest rate on the loan reprices 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 In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption ...
(FRA), which is a contract to pay a fixed rate of interest six months after purchases on a
notional amount The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...
of money. 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.


Speculation

Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the 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 less. Speculative trading in derivatives gained a great deal of notoriety in 1995 when
Nick Leeson Nicholas William Leeson (born 25 February 1967) is an English former derivatives trader whose fraudulent, unauthorized and speculative trades resulted in the 1995 collapse of Barings Bank Barings Bank was a British merchant bank based in ...
, a trader at
Barings Bank Barings Bank was a British merchant bank based in London, and one of England's List of oldest banks in continuous operation, oldest merchant banks after Berenberg Bank, Barings' close collaborator and German representative. It was founded in 1762 ...
, 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 The , or Kobe earthquake, occurred on January 17, 1995, at 05:46:53 JST (January 16 at 20:46:53 UTC) in the southern part of Hyōgo Prefecture is a Prefectures of Japan, prefecture of Japan located in the Kansai region of Honshu. Hyōgo ...
, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution."How Leeson broke the bank"
''BBC Economy''


Arbitrage

Individuals and institutions may also look for
arbitrage In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more Market (economics), markets; striking a combination of matching deals to capitalise on the difference, the profit being the di ...
opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.


Proportion used for hedging and speculation

The true proportion of derivatives contracts used for hedging purposes is unknown, but it appears to be relatively small. Also, derivatives contracts account for only 3–6% of the median firms' total currency and interest rate exposure.Knowledge@Wharton (2006)
"The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch?"
/ref> Nonetheless, we know that many firms' derivatives activities have at least some speculative component for a variety of reasons.


Types

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 derivatives

Over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...
(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 agreement In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption ...
s, exotic options – and other exotic derivatives – 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 fund A hedge fund is a pooled investment fund that trades in relatively Market liquidity, liquid assets and is able to make extensive use of more complex trader (finance), trading, portfolio (finance), portfolio-construction, and risk management techn ...
s. Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchanges According to the
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country ...
, who first surveyed OTC derivatives in 1995, reported that the " gross market value, which represent the cost of replacing all open contracts at the prevailing market prices, ... increased by 74% since 2004, to $11 trillion at the end of June 2007 (BIS 2007:24)." Positions in the OTC derivatives market increased to $516 trillion at the end of June 2007, 135% higher than the level recorded in 2004. The total outstanding notional amount is US$708 trillion (as of June 2011).BIS survey: The
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country ...
(BIS) semi-annua
OTC derivatives market report
for end of June 2008, showed US$683.7 trillion total
notional amount The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...
s outstanding of OTC derivatives with a gross market value of US$20 trillion. ''See als
Prior Period Regular OTC Derivatives Market Statistics
'.
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
counterparty risk A credit risk is risk of default (finance), default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal sum, principal and interest, disruptio ...
, like an ordinary
contract A contract is a legally enforceable agreement between two or more Party (law), parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, Service (economics), ser ...
, since each counter-party relies on the other to perform.


Exchange-traded derivatives

Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized
derivatives exchange A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivative (finance), derivatives contracts to buy or sell specific quantitie ...
s or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. 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''Futures and Options Week'': According to figures published in F&O Week October 10, 2005. See als
FOW Website
derivatives exchanges (by number of transactions) are the
Korea Exchange Korea Exchange (KRX) is the sole securities exchange operator in South Korea. It is headquartered in Busan, and has an office for cash markets and market oversight in Seoul. History The Korea Exchange was created through the integration of Ko ...
(which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and
CME Group CME Group Inc. (Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange, The Commodity Exchange) is an American global markets company. It is the world's largest financial derivatives exchange, and trades in asset class ...
(made up of the 2007 merger of the
Chicago Mercantile Exchange The Chicago Mercantile Exchange (CME) (often called "the Chicago Merc", or "the Merc") is a global derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board, an a ...
and the
Chicago Board of Trade The Chicago Board of Trade (CBOT), established on April 3, 1848, is one of the world's oldest futures exchange, futures and options exchanges. On July 12, 2007, the CBOT merged with the Chicago Mercantile Exchange (CME) to form CME Group. CBOT and ...
and the 2008 acquisition of the
New York Mercantile Exchange The New York Mercantile Exchange (NYMEX) is a commodity futures exchange owned and operated by CME Group of Chicago. NYMEX is located at One North End Avenue in Brookfield Place (New York City), Brookfield Place in the Battery Park City sectio ...
). According to BIS, the combined turnover in the world's derivatives exchanges totaled US$344 trillion during Q4 2005. By December 2007 the
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country ...
reported that "derivatives traded on exchanges surged 27% to a record $681 trillion."


Inverse ETFs and leveraged ETFs

Inverse exchange-traded funds (IETFs) and leveraged exchange-traded funds (LETFs) are two special types of exchange traded funds (ETFs) that are available to common traders and investors on major exchanges like the NYSE and Nasdaq. To maintain these products'
net asset value Net asset value (NAV) is the value of an entity's assets minus the value of its Liability (financial accounting), liabilities, often in relation to open-end fund, open-end, mutual fund, mutual funds, Hedge fund, hedge funds, and Venture capital, v ...
, these funds' administrators must employ more sophisticated
financial engineering Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of Mathematical programming, programming. It has also been defined as the application of technical methods ...
methods than what's usually required for maintenance of traditional ETFs. These instruments must also be regularly rebalanced and re-indexed each day.


Common derivative contract

Some of the common variants of derivative contracts are as follows: # Forwards: tailored contract between two parties, where payment takes place at a specific time in the future at today's pre-determined price. # Futures: contracts to buy or sell an asset on 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; the forward contract is a non-standardized contract written by the parties themselves. # Options: contracts that give the owner the right, but not the obligation, to buy (in the case of a
call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call Option (finance), option to exchange a Security (finance), security at a set price. The buyer of the call option has the righ ...
) or sell (in the case of a
put option In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
) an asset. The price at which the sale takes place is known as the
strike price In finance, the strike price (or exercise price) of an option (finance), option is a fixed price at which the owner of the option can buy (in the case of a call option, call), or sell (in the case of a put option, put), the underlying Security (f ...
, 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 In finance, the style or family of an option (finance), option is the class into which the option falls, usually defined by the dates on which the option may be Exercise (options), exercised. The vast majority of options are either European or Amer ...
, 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 In finance, the style or family of an option (finance), option is the class into which the option falls, usually defined by the dates on which the option may be Exercise (options), exercised. The vast majority of options are either European or Amer ...
, 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. Options are of two types:
call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call Option (finance), option to exchange a Security (finance), security at a set price. The buyer of the call option has the righ ...
and
put option In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
. # Binary options: contracts that provide the owner with an all-or-nothing profit profile. # Warrants: apart from the commonly used short-dated options which have a maximum maturity period of one year, there exist certain long-dated options as well, known as warrants. These are generally traded over the counter. # Swaps: 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 exchange A commodities exchange is an Exchange (organized market), exchange, or market, where various Commodity, commodities are traded. Most commodity markets around the world trade in agricultural products and other raw materials (like wheat, barley, ...
, stocks or other assets. ::Swaps can basically be categorized into
Interest rate swap In finance, an interest rate swap (finance), swap (IRS) is an interest rate derivative, interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a Interest_rate_derivative#Linear_and_non-linear ...
and
Currency swap In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
. Some common examples of these derivatives are the following:


Collateralized debt obligation

A
collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured finance, structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing Mortgage-backed se ...
( CDO) is a type of structured asset-backed security (ABS). An "asset-backed security" is used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities (MBS) (Example: "The capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs".)—and sometimes for a particular type of that security—one backed by consumer loans (example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO, nd
Securitization Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling ...
issues backed by consumer-backed products—car loans, consumer loans and credit cards, among others—are called ABS.) Originally developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgage-backed security (MBS) markets.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', §5:15 (Thomson West, 2014). Like other private-label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently,
coupon In marketing, a coupon is a ticket or document that can be redeemed for a financial discounts and allowances, discount or rebate (marketing), rebate when purchasing a product (business), product. Customarily, coupons are issued by manufacturers ...
payments (and interest rates) vary by tranche with the safest/most senior tranches paying the lowest and the lowest tranches paying the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.Lemke, Lins and Smith, ''Regulation of Investment Companies'' (Matthew Bender, 2014 ed.). Separate special-purpose entities—rather than the parent
investment bank Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...
—issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration called " CDO-Squared" or the "CDOs of CDOs". In the early 2000s, CDOs were generally diversified, but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this changed. CDO collateral became dominated not by loans, but by lower level ( BBB or A) tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages."Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States"
a.k.a. "The Financial Crisis Inquiry Report", p.127
These CDOs have been called "the engine that powered the mortgage supply chain" for nonprime mortgages,''The Financial Crisis Inquiry Report'', 2011, p.130 and are credited with giving lenders greater incentive to make non-prime loans''The Financial Crisis Inquiry Report'', 2011, p.133 leading up to the 2007-9
subprime mortgage crisis The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
.


Credit default swap

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan
default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance), failure to satisfy the terms of a loan obligation or failure to pay back a loan ** Default judgment, a binding judgment in favor of eit ...
(by the debtor) or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from
JP Morgan JPMorgan Chase & Co. is an American multinational investment bank Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, ...
in 1994. In the event of default the buyer of the CDS receives compensation (usually the
face value The face value, sometimes called nominal value, is the value of a coin A coin is a small, flat (usually depending on the country or value), round piece of metal A metal (from ancient Greek, Greek μέταλλον ''métallon'', "min ...
of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone with sufficient collateral to trade with a bank or hedge fund can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct
insurable interest Insurable interest exists when an Insurance, insured person derives a financial or other kind of benefit from the continuous existence, without repairment or damage, of the insured object (or in the case of a person, their continued survival). A pe ...
in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan. Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010"ISDA 2010 Mid-Year Market Survey"
. Latest available a/o March 1, 2012.
but reportedly $25.5 trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007–2010 financial crisis the lack of transparency in this large market became a concern to regulators as it could pose a
systemic risk In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpt ...
. In March 2010, the TCCTrade Information Warehouse announced it would give regulators greater access to its credit default swaps database. CDS data can be used by financial professionals, regulators, and the media to monitor how the market views
credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
of any entity on which a CDS is available, which can be compared to that provided by
credit rating agencies A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may r ...
. U.S. courts may soon be following suit. Most CDSs are documented using standard forms drafted by the
International Swaps and Derivatives Association International is an adjective (also used as a noun) meaning "between nations". International may also refer to: Music Albums * International (Kevin Michael album), ''International'' (Kevin Michael album), 2011 * International (New Order album), ' ...
(ISDA), although there are many variants. In addition to the basic, single-name swaps, there are
basket A basket is a container that is traditionally constructed from stiff fibers and can be made from a range of materials, including wood splints, runners, and cane. While most baskets are made from plant materials, other materials such as horsehai ...
default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a
special-purpose vehicle A special-purpose entity (SPE; or, in Europe and India, special-purpose vehicle/SPV; or, in some cases in each EU jurisdiction, FVC, financial vehicle corporation) is a legal entity (usually a company (law), limited company of some type or, somet ...
issuing asset-backed securities. Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency. A CDS can be unsecured (without collateral) and be at higher risk for a default.


Forwards

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at an amount agreed upon today, making it a type of derivative instrument. This is in contrast to a
spot contract In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or selling a commodity, security (finance), security or currency for immediate Settlement (finance), settlement (payment and delivery) on the spot date, whic ...
, which is an agreement to buy or sell an asset on its spot date, which may vary depending on the instrument, for example most of the FX contracts have Spot Date two business days from today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a
short position In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consu ...
. The price agreed upon is called the delivery price, which is equal to the
forward price The forward price (or sometimes forward rate) is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, for a forward contract on an underlying asset that is tradeable, the forward price can be expressed in t ...
at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the
securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
themselves are exchanged. The
forward price The forward price (or sometimes forward rate) is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, for a forward contract on an underlying asset that is tradeable, the forward price can be expressed in t ...
of such a contract is commonly contrasted with the
spot price In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or selling a commodity, security (finance), security or currency for immediate Settlement (finance), settlement (payment and delivery) on the spot date, whic ...
, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a
profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting, is an income distributed to the ownership , owner in a Profit (economics) , profitable market production process (business). Profit is a measure of profi ...
, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to
hedge A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoini ...
risk (typically currency or exchange rate risk), as a means of
speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline i ...
, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a
futures contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures—such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded
over the counter Over-the-counter (OTC) drugs are medication, medicines sold directly to a consumer without a requirement for a medical prescription, prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to co ...
( OTC), forward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain. In other words, the terms of the forward contract will determine the collateral calls based upon certain "trigger" events relevant to a particular counterparty such as among other things, credit ratings, value of assets under management or redemptions over a specific time frame (e.g., quarterly, annually).


Futures

In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption (economics) ...
, a 'futures contract' (more colloquially, futures) is a standardized
contract A contract is a legally enforceable agreement between two or more Party (law), parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, Service (economics), ser ...
between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the ''futures price'') with delivery and payment occurring at a specified future date, the ''delivery date'', making it a derivative product (i.e. a financial product that is derived from an underlying asset). The contracts are negotiated at a
futures exchange A futures exchange or futures market is a central financial exchange where people can trade standardized futures contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not syno ...
, which acts as an intermediary between buyer and seller. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be " long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be " short". While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange is to act as intermediary and mitigate the risk of default by either party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial amount of cash (performance bond), the margin. Margins, sometimes set as a percentage of the value of the futures contract, need to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically be making or losing money. To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis. This is sometimes known as the variation margin where the futures exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account. If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as "marking to market". Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (i.e., the original value agreed upon, since any gain or loss has already been previously settled by marking to market). Upon marketing the strike price is often reached and creates much income for the "caller". A closely related contract is a
forward contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpt ...
. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange. Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures
position Position often refers to: * Position (geometry) In geometry, a position or position vector, also known as location vector or radius vector, is a Euclidean vector that represents the position of a Point (geometry), point ''P'' in space#Classical ...
can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss..


Mortgage-backed securities

A mortgage-backed security (MBS) is an
asset-backed security An asset-backed security (ABS) is a security Security is protection from, or resilience against, potential harm (or other unwanted Coercion, coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (techni ...
that is secured by a
mortgage A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners ...
, or more commonly a collection ("pool") of sometimes hundreds of
mortgages A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners ...
. The mortgages are sold to a group of individuals (a government agency or investment bank) that " securitizes", or packages, the loans together into a security that can be sold to investors. The mortgages of an MBS may be
residential A residential area is a land used in which houses, housing predominates, as opposed to industrial district, industrial and Commercial Area, commercial areas. Housing may vary significantly between, and through, residential areas. These includ ...
or
commercial Commercial may refer to: * a dose of advertising conveyed through media (such as - for example - radio or television) ** Radio advertisement ** Television advertisement * (adjective for:) commerce, a system of voluntary exchange of products and s ...
, depending on whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be issued by structures set up by
government-sponsored enterprise A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress. Their intended function is to enhance the flow of Credit (finance), credit to targeted sectors of the economy, to make tho ...
s like
Fannie Mae The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a United States government-sponsored enterprise (GSE) and, since 1968, a publicly traded company. Founded in 1938 during the Great Depression as part of the New ...
or
Freddie Mac The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, is a publicly traded, government-sponsored enterprise (GSE), headquartered in Tyson's Corner, Virginia, Tysons Corner, Virginia.collateralized mortgage obligation A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor need ...
s (CMOs, often structured as real estate mortgage investment conduits) and
collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured finance, structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing Mortgage-backed se ...
s (CDOs). The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as
tranche In structured finance, a tranche is one of a number of related Security (finance), securities offered as part of the same transaction. In the financial sense of the word, each Bond (finance), bond is a different slice of the deal's risk. Transac ...
s (French for "slices"), each with a different level of priority in the debt repayment stream, giving them different levels of risk and reward. Tranches—especially the lower-priority, higher-interest tranches—of an MBS are/were often further repackaged and resold as collaterized debt obligations. These subprime MBSs issued by investment banks were a major issue in the
subprime mortgage crisis The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
of 2006–2008 . The total face value of an MBS decreases over time, because like mortgages, and unlike bonds, and most other fixed-income securities, the principal in an MBS is not paid back as a single payment to the bond holder at maturity but rather is paid along with the interest in each periodic payment (monthly, quarterly, etc.). This decrease in face value is measured by the MBS's "factor", the percentage of the original "face" that remains to be repaid.


Options

In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption (economics) ...
, an option is a contract which gives the ''buyer'' (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified
strike price In finance, the strike price (or exercise price) of an option (finance), option is a fixed price at which the owner of the option can buy (in the case of a call option, call), or sell (in the case of a put option, put), the underlying Security (f ...
on or before a specified date. The ''seller'' has the corresponding obligation to fulfill the transaction—that is to sell or buy—if the buyer (owner) "exercises" the option. The buyer pays a premium to the seller for this right. An option that conveys to the owner the right to buy something at a certain price is a "
call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call Option (finance), option to exchange a Security (finance), security at a set price. The buyer of the call option has the righ ...
"; an option that conveys the right of the owner to sell something at a certain price is a "
put option In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
". Both are commonly traded, but for clarity, the call option is more frequently discussed. Options valuation is a topic of ongoing research in academic and practical finance. In basic terms, the value of an option is commonly decomposed into two parts: * The first part is the "intrinsic value", defined as the difference between the market value of the underlying and the strike price of the given option. * The second part is the "time value", which depends on a set of other factors which, through a multivariable, non-linear interrelationship, reflect the
discounted Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee.See "Time Value", "Discount", "Discount Yield", "Compound Interest", "Efficient ...
expected value In probability theory, the expected value (also called expectation, expectancy, mathematical expectation, mean, average, or first moment) is a generalization of the weighted average. Informally, the expected value is the arithmetic mean of a l ...
of that difference at expiration. Although options valuation has been studied since the 19th century, the contemporary approach is based on the
Black–Scholes model The Black–Scholes or Black–Scholes–Merton model is a mathematical model A mathematical model is a description of a system using mathematical concepts and language Language is a structured system of communication. The structure ...
, which was first published in 1973. Options contracts have been known for many centuries. However, both trading activity and academic interest increased when, as from 1973, options were issued with standardized terms and traded through a guaranteed clearing house at the
Chicago Board Options Exchange The Chicago Board Options Exchange (CBOE), located at 433 West Van Buren LaSalle Street, Street in Chicago, Illinois, Chicago, is the largest U.S. option (finance), options exchange with an annual trading volume of around 1.27 billion at the end ...
. Today, many options are created in a standardized form and traded through clearing houses on regulated options exchanges, while other
over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...
options are written as bilateral, customized contracts between a single buyer and seller, one or both of which may be a dealer or market-maker. Options are part of a larger class of financial instruments known as
derivative products In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, Index fund, index, or interest rate, and is often simply called the "underlying". Derivative ...
or simply derivatives.


Swaps

A swap is a derivative in which two counterparties exchange cash flows of one party's
financial instrument Financial instruments are monetary Contract, contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in ...
for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (
coupon In marketing, a coupon is a ticket or document that can be redeemed for a financial discounts and allowances, discount or rebate (marketing), rebate when purchasing a product (business), product. Customarily, coupons are issued by manufacturers ...
) payments associated with such bonds. Specifically, two counterparties agree to the exchange one stream of
cash flow A cash flow is a real or virtual movement of cash, money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are exp ...
s against another stream. These streams are called the swap's "legs". The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated. Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a
floating interest rate A floating interest rate, also known as a variable or adjustable rate, refers to any type of debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a ...
, foreign exchange rate, equity price, or commodity price. The cash flows are calculated over a notional principal amount. Contrary to a
future The future is the time after the past and present. Its arrival is considered inevitable due to the existence of time and the laws of physics. Due to the apparent nature of reality and the unavoidability of the future, everything that currently ...
, a forward or an option, the notional amount is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to
hedge A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoini ...
certain risks such as
interest rate risk In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpt ...
, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the
World Bank The World Bank is an international financial institution that provides loans and Grant (money), grants to the governments of Least developed countries, low- and Developing country, middle-income countries for the purpose of pursuing capital pro ...
entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more than $348 trillion in 2010, according to the
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country ...
(BIS). The five generic types of swaps, in order of their quantitative importance, are:
interest rate swap In finance, an interest rate swap (finance), swap (IRS) is an interest rate derivative, interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a Interest_rate_derivative#Linear_and_non-linear ...
s,
currency swap In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
s, credit swaps, commodity swaps and equity swaps (there are many other types).


Economic function of the derivative market

Some of the salient economic functions of the derivative market include: # Prices in a structured
derivative market The derivatives market is the financial market for derivative (finance), derivatives, financial instruments like futures contracts or options, which are derived from other forms of Underlying asset, assets. The market can be divided into two, t ...
not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices. # The derivatives market reallocates risk from the people who prefer
risk aversion In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more ce ...
to the people who have an appetite for risk. # The intrinsic nature of derivatives market associates them to the underlying
spot market The spot market or cash market is a market (place), public financial market in which financial instrument, financial instruments or commodity, commodities are traded for spot date, immediate delivery. It contrasts with a futures exchange, futur ...
. Due to derivatives there is a considerable increase in trade volumes of the underlying spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk. # As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market,
speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline i ...
can be controlled, resulting in a more meticulous environment. # Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts. In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative
market participant The term market participant is another term for economic agent, an actor and more specifically a decision maker in a Economic model, model of some aspect of the economy. For example, ''buyers'' and ''sellers'' are two common types of agents in part ...
.


Valuation


Market and arbitrage-free prices

Two common measures of value are: *
Market price A price is the (usually not negative) quantity of payment or Financial compensation, compensation given by one Party (law), party to another in return for Good (economics), goods or Service (economics), services. In some situations, the pr ...
, i.e. the price at which traders are willing to buy or sell the contract *
Arbitrage In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more Market (economics), markets; striking a combination of matching deals to capitalise on the difference, the profit being the di ...
-free price, meaning that no risk-free profits can be made by trading in these contracts (see ''
rational pricing Rational pricing is the assumption in financial economics Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to ap ...
'')


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 can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of
financial mathematics Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets. In general, there exist two separate branches of finance that require ...
. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities. However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the
stochastic process In probability theory and related fields, a stochastic () or random process is a mathematical object usually defined as a Indexed family, family of random variables. Stochastic processes are widely used as mathematical models of systems and phen ...
of the price of the underlying asset is often crucial. A key equation for the theoretical
valuation of options In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption ...
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. Most of the model's results are input-dependent (meaning the final price depends heavily on how we derive the pricing inputs). 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).


Risks

Derivatives are often subject to the following criticisms; particularly since the
Financial crisis of 2007–2008 Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption (economics) ...
, the discipline of
Risk management Risk management is the identification, evaluation, and prioritization of risks (defined in ISO 31000 as ''the effect of uncertainty on objectives'') followed by coordinated and economical application of resources to minimize, monitor, and con ...
has developed attempting to address the below and other risks - see .


Hidden tail risk

According to Raghuram Rajan, a former chief economist of the
International Monetary Fund The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution, headquartered in Washington, D.C., consisting of 190 countries. Its stated mission is "working to foster globa ...
(IMF), "... it may well be that the managers of these firms nvestment fundshave figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one – a phenomenon they term "phase lock-in". A hedged position "can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected". See the FRTB framework, which seeks to address this to some extent.


Leverage

The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow
investor An investor is a person who allocates financial capital with the expectation of a future Return on capital, return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some specie ...
s 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 following: :*
American International Group American International Group, Inc. (AIG) is an American multinational finance and insurance corporation with operations in more than 80 countries and jurisdictions. , AIG companies employed 49,600 people.https://www.aig.com/content/dam/aig/amer ...
(AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on
credit default swap A credit default swap (CDS) is a Swap (finance), financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt Default (finance), default (by the debtor) or other credit event. That is, the seller of the ...
s (CDSs). The United States
Federal Reserve Bank A Federal Reserve Bank is a regional bank of the Federal Reserve System, the central banking system of the United States. There are twelve in total, one for each of the twelve Federal Reserve Districts that were created by the Federal Reserve A ...
announced the creation of a secured credit facility of up to US$85 billion, to prevent the company's collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners. :* 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 Long-Term Capital Management L.P. (LTCM) was a Leverage (finance), highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York. LT ...
in 1998. :* The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG. :* The loss of US$1.2 billion equivalent in equity derivatives in 1995 by
Barings Bank Barings Bank was a British merchant bank based in London, and one of England's List of oldest banks in continuous operation, oldest merchant banks after Berenberg Bank, Barings' close collaborator and German representative. It was founded in 1762 ...
. :*UBS AG, Switzerland's biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September 2011. Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net ...
in
Berkshire Hathaway Berkshire Hathaway Inc. () is an American Multinational corporation, multinational conglomerate (company), conglomerate holding company headquartered in Omaha, Nebraska, United States. Its main business and source of capital is insurance, from ...
's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' A potential problem with derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in the underlying capital and equities markets themselves. 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 indicato
(See Berkshire Hathaway Annual Report for 2002)


Counter party risk

Some derivatives (especially swaps) expose investors to
counterparty risk A credit risk is risk of default (finance), default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal sum, principal and interest, disruptio ...
, or risk arising from the other party in a financial transaction. 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.


Financial reform and government regulation

Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form to extend credit. The strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency however, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to conceal credit risk from third parties while protecting derivative counterparties contributed to the financial crisis of 2008 in the United States. In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body,
Gary Gensler Gary Gensler (born October 18, 1957) is an American government official and former investment banker serving as the chair of the U.S. Securities and Exchange Commission. Gensler previously led the Presidential transition of Joe Biden, Biden–Ha ...
, the chairman of the
Commodity Futures Trading Commission The Commodity Futures Trading Commission (CFTC) is an Independent agencies of the United States government, independent agency of the US government created in 1974 that regulates the U.S. derivatives markets, which includes futures contract, futu ...
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, " e 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." For legislators and committees responsible for financial reform related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative derivatives activities has been a nontrivial challenge. The distinction is critical because regulation should help to isolate and curtail speculation with derivatives, especially for "systemically significant" institutions whose default could be large enough to threaten the entire financial system. At the same time, the legislation should allow for responsible parties to hedge risk without unduly tying up working capital as collateral that firms may better employ elsewhere in their operations and investment. In this regard, it is important to distinguish between financial (e.g. banks) and non-financial end-users of derivatives (e.g. real estate development companies) because these firms' derivatives usage is inherently different. More importantly, the reasonable collateral that secures these different counterparties can be very different. The distinction between these firms is not always straight forward (e.g. hedge funds or even some private equity firms do not neatly fit either category). Finally, even financial users must be differentiated, as 'large' banks may classified as "systemically significant" whose derivatives activities must be more tightly monitored and restricted than those of smaller, local and regional banks. Over-the-counter dealing will be less common as the
Dodd–Frank Wall Street Reform and Consumer Protection Act The Dodd–Frank Wall Street Reform and Consumer Protection Act, commonly referred to as Dodd–Frank, is a United States federal law that was enacted on July 21, 2010. The law overhauled financial regulation in the aftermath of the Great Recessi ...
comes into effect. The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on derivatives. To implement Dodd-Frank, th
CFTC developed new rules in at least 30 areas
The Commission determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a certain type of swap contract. Nonetheless, the above and other challenges of the rule-making process have delayed full enactment of aspects of the legislation relating to derivatives. The challenges are further complicated by the necessity to orchestrate globalized financial reform among the nations that comprise the world's major financial markets, a primary responsibility of the
Financial Stability Board The Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system. It was established after the 2009 G20 London summit, G20 London summit in April 2009 as a successor to the Fi ...
whose progress is ongoing. In the U.S., by February 2012 the combined effort of the SEC and CFTC had produced over 70 proposed and final derivatives rules. However, both of them had delayed adoption of a number of derivatives regulations because of the burden of other rulemaking, litigation and opposition to the rules, and many core definitions (such as the terms "swap", "security-based swap", "swap dealer", "security-based swap dealer", "major swap participant" and "major security-based swap participant") had still not been adopted. SEC Chairman Mary Schapiro opined: "At the end of the day, it probably does not make sense to harmonize everything etween the SEC and CFTC rulesbecause some of these products are quite different and certainly the market structures are quite different." On February 11, 2015, the Securities and Exchange Commission (SEC) released two final rules toward establishing a reporting and public disclosure framework for security-based swap transaction data. The two rules are not completely harmonized with the requirements with CFTC requirements. In November 2012, the SEC and regulators from Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been agreed by leaders at the
2009 G-20 Pittsburgh summit The 2009 G20 Pittsburgh Summit was the third meeting of the G20 heads of state/heads of government to discuss financial market A financial market is a market (economics), market in which people trade financial Security (finance), securiti ...
in September 2009. In December 2012, they released a joint statement to the effect that they recognized that the market is a global one and "firmly support the adoption and enforcement of robust and consistent standards in and across jurisdictions", with the goals of mitigating risk, improving transparency, protecting against market abuse, preventing regulatory gaps, reducing the potential for
arbitrage In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more Market (economics), markets; striking a combination of matching deals to capitalise on the difference, the profit being the di ...
opportunities, and fostering a level playing field for market participants. They also agreed on the need to reduce regulatory uncertainty and provide market participants with sufficient clarity on laws and regulations by avoiding, to the extent possible, the application of conflicting rules to the same entities and transactions, and minimizing the application of inconsistent and duplicative rules. At the same time, they noted that "complete harmonization – perfect alignment of rules across jurisdictions" would be difficult, because of jurisdictions' differences in law, policy, markets, implementation timing, and legislative and regulatory processes. On December 20, 2013 the CFTC provided information on its swaps regulation "comparability" determinations. The release addressed the CFTC's cross-border compliance exceptions. Specifically it addressed which entity level and in some cases transaction-level requirements in six jurisdictions (Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland) it found comparable to its own rules, thus permitting non-US swap dealers, major swap participants, and the foreign branches of US Swap Dealers and major swap participants in these jurisdictions to comply with local rules in lieu of Commission rules.


Reporting

Mandatory reporting regulations are being finalized in a number of countries, such as Dodd Frank Act in the US, the European Market Infrastructure Regulations (EMIR) in Europe, as well as regulations in Hong Kong, Japan, Singapore, Canada, and other countries. The OTC Derivatives Regulators Forum (ODRF), a group of over 40 worldwide regulators, provided trade repositories with a set of guidelines regarding data access to regulators, and the Financial Stability Board and CPSS IOSCO also made recommendations in with regard to reporting. DTCC, through its "Global Trade Repository" (GTR) service, manages global trade repositories for interest rates, and commodities, foreign exchange, credit, and equity derivatives. It makes global trade reports to the CFTC in the U.S., and plans to do the same for ESMA in Europe and for regulators in Hong Kong, Japan, and Singapore. It covers cleared and uncleared OTC derivatives products, whether or not a trade is electronically processed or bespoke.


Glossary

* 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. *
Counterparty A counterparty (sometimes contraparty) is a Juristic person, legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the ...
: The legal and financial term for the other party in a financial transaction. * Credit derivative: A contract that transfers
credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as
credit default swap A credit default swap (CDS) is a Swap (finance), financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt Default (finance), default (by the debtor) or other credit event. That is, the seller of the ...
s, 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 contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
s and options) that are transacted on an organized
futures exchange A futures exchange or futures market is a central financial exchange where people can trade standardized futures contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not syno ...
. * 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 U.S. Federal Financial Institutions Examination Council policy statement on high-risk mortgage securities. *
Notional amount The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...
: 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 Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...
(OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges. * Structured notes: Non-mortgage-backed
debt securities A security is a tradable financial asset A financial asset is a non-physical asset whose value is derived from a contractual claim, such as deposit (finance), bank deposits, bond (finance), bonds, and participations in companies' share capital ...
, 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 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement.By definition of Bank for International Settlements. These forms of banking capital were largely standardized in the ...
. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with noncumulative dividends,
retained earnings The retained earnings (also known as plowback) of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that peri ...
, and
minority interest In accounting, minority interest (or non-controlling interest) is the portion of a subsidiary corporation's stock that is not owned by the parent corporation. The magnitude of the minority interest in the subsidiary company is generally less than 5 ...
s in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of
subordinated debt In finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts if a company falls into liquidation or bankruptcy. Such debt is referred to as 'subordi ...
, intermediate-term
preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...
, cumulative and long-term preferred stock, and a portion of a bank's allowance for loan and lease losses.


See also

* Credit derivative * Derivatives law * Equity derivative * Exotic derivative *
Financial engineering Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of Mathematical programming, programming. It has also been defined as the application of technical methods ...
*
Foreign exchange derivative A foreign exchange derivative is a financial derivative In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, Index fund, index, or interest rat ...
*
Freight derivative The international shipping industry can be divided into four closely related shipping markets, each trading in a different commodity: the freight market, the sale and purchase market, the newbuilding market and the ship breaking, demolition market. ...
* Inflation derivative *
Interest rate derivative In finance, an interest rate derivative (IRD) is a derivative (finance), derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There a ...
* Property derivatives * Weather derivative


References


Further reading

* * * * * * * * * * * Nassim N. Taleb (1996). “Dynamic Hedging: Managing Vanilla and Exotic Options”. Wiley.


External links


''Understanding Derivatives: Markets and Infrastructure''
(
Federal Reserve Bank of Chicago The Federal Reserve Bank of Chicago (informally the Chicago Fed) is one of twelve Federal Reserve System, regional Reserve Banks that, along with the Federal Reserve Board of Governors, make up the United States' central bank. The Chicago Reserve ...
)
"Derivatives simple guide"
BBC News
''Investment-foundations: Derivatives''
,
CFA Institute The CFA Institute is a global, not-for-profit professional organization that provides investment professionals with finance education. The institute aims to promote standards in ethics, education, and professional excellence in the global investme ...

"European Union proposals on derivatives regulation – 2008 onwards"

" Derivatives Regulatory Roulette"
PwC Financial Services Regulatory Practice (December 2013) {{DEFAULTSORT:Derivative (Finance) Securities (finance) Financial law Wagering