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Derivative security

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In finance, a derivative security is a contract that specifies the rights and obligations between the issuer of the security and the holder to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event.

Contents

Properties

A derivate can have a large number of properties, so that its value depends on many factors. The terms and payments can be derived from the price of a security or commodity, a published statistics, an event (such as default on payment), or something else.

Derivatives which are fully standardized like futures and many options are generally traded through a securities exchange or futures exchange. "Over-the-counter" derivatives are negotiated privately between parties, and the terms can generally be customized to meet the parties' needs. Those standardized contracts traded on an exchange will generally have much greater liquidity.

The fundamental nature of a derivative is that unlike a bond, as in a Treasury bond, or a stock, or even physical stock or commodity (ie: some raw material, product), a derivative has no physicalistic purpose or reason for existence.

Cash flow

The payments between the parties may be determined by:

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

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.

Types of derivatives

Common examples of derivatives are: (with the notional amount on open OTC contracts in Dec 2003 according to the BIS in $ billions) ([1] (http://www.bis.org/publ/regpubl.htm))

By underlying security:

Some less common examples are:

Glossary

From: Quarterly Derivatives Fact Sheet (http://www.occ.treas.gov/deriv/deriv.htm)

  • Bilateral Netting: A legally enforceable arrangement between a bank and a counterparty that creates a single legal obligation covering all included individual contracts. This means that a bank’s obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.
  • Credit Derivative: A contract which transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default options, credit limited notes and total return swaps.
  • Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.
  • Gross Negative Fair Value: The sum total of the fair values of contracts where the bank owes money to its counterparties, without taking into account netting. This represents the maximum losses the bank’s counterparties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counterparties.
  • Gross Positive Fair Value: The sum total of the fair values of contracts where the bank is owed money by its counterparties, without taking into account netting. This represents the maximum losses a bank could incur if all its counterparties default and there is no netting of contracts, and the bank holds no counterparty collateral.
  • High-Risk Mortgage Securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities.
  • Notional Amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional.
  • Structured Notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and/or have embedded forwards or options.

Valuation

The central topic of financial mathematics is the fair valuation of derivatives. Whereas "fair" refers to the absence of arbitrage, meaning that no riskless profits can be made by trading in assets. A key equation is the Black-Scholes formula, that made it possible to replicate a stock option by a continuous buying and selling strategy in the plain stock. Crucial to the valuation of derivatives is also the stochastics of the underlying assets, typically expressed as a stochastic process.

BIS survey

The Swiss BIS bank i their Regular OTC Derivatives Market Statistics (http://www.bis.org/publ/otc_hy0412.htm) from 6 December 2004 that, in the middle of 2004, notional amounts on outstanding Over The Counter (OTC) contracts had a notional amount of $220.058 trillion with a gross market value of $6.394 trillion.

Usages

One use of derivative securities is as a tool to transfer risk. For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads (or hedges) the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop that he will grow; the speculator will make a profit if the price rises, but also risks making a loss if the price falls.

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

Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgment on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events, Leeson incurred a 1.3 billion dollar loss that bankrupted the centuries old financial institution.

DARPA also examined the idea of developing a futures market for world events, the Policy Analysis Market, noting that futures markets are unusually efficient at gathering and processing information. The idea was halted due to political uproar.

General Electric

This company uses derivatives to "match funding" (GE webcast on derivatives (http://www.ge.com/en/company/investor/webcast/webcast_05062005.htm)) to mitigate interest rate and currency risk, to lock in material cost. It's 100% for planning purposes, not to earn money, so it's not a hedge fund. 90% of all derivatives revenue made by derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable planning.

On 05/06-2005 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003 (Revised 2004 10K (PDF, 787 KB) (http://www.ge.com/en/company/investor/secreport/ge_10ka_2004.htm)).

Opinions

Although there have been instances of massive losses, most notably by Long-Term Capital Management, these have not had repercussions. Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Because derivative securities offer the possibility of large rewards, many individuals have the strong desire to invest in derivative securities. Most financial planners caution against this, pointing out that an investor in derivative securities often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor ([3] (http://news.bbc.co.uk/1/hi/business/2817995.stm)). One should keep in mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative.

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

There is the danger, however, that someone would lose so much money that they would be unable to pay for their losses. This might cause chain reactions which could create an economic crisis. In 2002, legendary investor Warren Buffett commented in an interview with the New York Times that he had accumulated his wealth without the use of derivatives and that he regarded them as 'financial weapons of mass destruction', an allusion to the phrase 'weapons of mass destruction' relating to physical weapons which had wide currency at the time.

See also

Associations

Lists

External links

Associations


Risk

  • Quantnotes.com (http://www.quantnotes.com/fundamentals/) - introductory articles covering mathematical finance
  • Riskglossary.com (http://www.riskglossary.com/) - an online glossary, encyclopedia, and resource locator
  • Option Tutor (http://secure.webstation.net/~ftsweb/texts/optiontutor/optutcontents.htm) - a visual presentation of modern option pricing theory
  • Riskworx.com (http://www.riskworx.com/res_inst.php) - discussion of the application and theory of derivatives

Articles

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