Derivative (finance)

From Wikipedia, the free encyclopedia

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, or interest rate, and is often called the
"underlying".[1][2] Derivatives can be used for a number of purposes, including insuring against price
movements (hedging), increasing exposure to price movements for speculation or getting access to
otherwise hard-to-trade assets or markets.[3] Some of the more common derivatives
include forwards,futures, options, swaps, and variations of these such as synthetic collateralized
debt obligations and credit default swaps. Most derivatives are traded over-the-counter (offexchange) or on an exchange such as the Chicago Mercantile Exchange, while
most insurance contracts have developed into a separate industry. Derivatives are one of the three
main categories of financial instruments, the other two being stocks (i.e., equities or shares)
and debt (i.e., bonds and mortgages).

Collateralised debt obligation[edit]

A collateralised debt obligation (CDO) is a type of structured asset-backed security (ABS).
[4]

Originally developed for the corporate debt markets, over time CDOs evolved to encompass the

mortgage and mortgage-backed security (MBS) markets.[5] 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.[6] 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 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.[7]
Separate special purpose entitiesrather than the parent investment bankissue 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".[7] In the early 2000s, CDOs were generally
diversified,[8] but by 20062007when the CDO market grew to hundreds of billions of dollarsthis
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.
[9]

These CDOs have been called "the engine that powered the mortgage supply chain" for nonprime

mortgages,[10] and are credited with giving lenders greater incentive to make non-prime
loans[11] leading up to the 2007-9 subprime mortgage crisis.

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 (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 in 1994. In the event of default the buyer of the CDS receives
compensation (usually the face value of the loan), and the seller of the CDS takes possession of the
defaulted loan.[12]However, anyone can purchase a CDS, even buyers who do not hold the loan
instrument and who have no direct insurable interest 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.
[13]

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,[14] falling to $26.3 trillion by mid-year
2010[15] but reportedly $25.5[16] trillion in early 2012. CDSs are not traded on an exchange and there is
no required reporting of transactions to a government agency.[17] 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.[18][19][20][21] In March 2010, the [DTCC] Trade Information Warehouse (seeSources of
Market Data) announced it would give regulators greater access to its credit default swaps database.
[22]

CDS data can be used by financial professionals, regulators, and the media to monitor how the

market views credit risk of any entity on which a CDS is available, which can be compared to that
provided by credit rating agencies. U.S. courts may soon be following suit.[12] Most CDSs are
documented using standard forms drafted by the International Swaps and Derivatives
Association (ISDA), although there are many variants.[18] In addition to the basic, single-name swaps,
there are basketdefault 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 issuingasset-backed securities.[23] Some claim
that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy
with a lack of transparency.[19] 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 a price agreed upon today, making it a
type of derivative instrument.[24][25] This is in contrast to a spot contract, 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 ashort position. The price agreed upon is called the delivery price, which is equal to
the forward price 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 themselves are exchanged.
The forward price of such a contract is commonly contrasted with the spot price, 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, or loss,
by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk
(typically currency or exchange rate risk), as a means of speculation, 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; they differ in certain respects. Forward contracts are
very similar to futures contracts, except they are not exchange-traded, or defined on standardized
assets.[26] Forwards also typically have no interim partial settlements or "true-ups" in margin
requirements like futuressuch 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 (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. [clarification
needed]

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, a futures contract (more colloquially, futures) is a standardized contract 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, 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 lots of income for the "caller".
A closely related contract is a forward contract. 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 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 a asset-backed security that is secured by a mortgage, or
more commonly a collection ("pool") of sometimes hundreds of mortgages. 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 or commercial, 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

enterprises like Fannie Mae orFreddie Mac, or they can be "private-label", issued by structures set
up by investment banks. The structure of the MBS may be known as "pass-through", where the
interest and principal payments from the borrower or homebuyer pass through it to the MBS holder,
or it may be more complex, made up of a pool of other MBSs. Other types of MBS
include collateralized mortgage obligations (CMOs, often structured as real estate mortgage
investment conduits) and collateralized debt obligations (CDOs).[27]
The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but
rather issued as tranches(French for "slices"), each with a different level of priority in the debt
repayment stream, giving them different levels of risk and reward. Tranchesespecially the lowerpriority, higher-interest tranchesof an MBS are/were often further repackaged and resold as
collaterized debt obligations.[28] These subprime MBSs issued by investment banks were a major
issue in thesubprime mortgage crisis of 20062008 . 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, an option is a contract which gives the buyer (the owner) the right, but not the obligation,
to buy or sell anunderlying asset or instrument at a specified strike price on or before a
specified date. The seller has the corresponding obligation to fulfill the transactionthat is to sell or
buyif 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"; an option that conveys the right of the owner to sell something at a certain price is a "put
option". 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 expected value of that difference
at expiration.

Although options valuation has been studied since the 19th century, the contemporary approach is
based on the BlackScholes model, which was first published in 1973.[29][30]
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 theChicago Board Options Exchange. Today many options
are created in a standardized form and traded through clearing houses on regulated options
exchanges, while other over-the-counter 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 or simply derivatives.
[24][31]

Swaps
A swap is a derivative in which two counterparties exchange cash flows of one party's financial
instrument 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) payments associated with such bonds.
Specifically, two counterparties agree to exchange one stream of cash flows 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, foreign exchange rate, equity price, or commodity price.[24]
The cash flows are calculated over a notional principal amount. Contrary to a future, 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 certain risks such as interest rate
risk, 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 entered into a swap
agreement.[32] 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 thn $348 trillion in 2010,
according to the Bank for International Settlements (BIS).[citation needed]The five generic types of swaps, in
order of their quantitative importance, are: interest rate swaps, currency swaps, credit
swaps, commodity swaps and equity swaps (there are many other types).

Financial derivative trading companies

Alpari

Anyoption

AvaTrade

Banc de Binary

Cantor Fitzgerald

CitiFXPro

City Index Group

CMC Markets

CommexFX

Cu

Darwinex

DBFX

EToro

ETX Capital

Finspreads

First Prudential Markets

FXCM

FXdirekt Bank

FXOpen

FXPro

Gain Capital

Hirose Financial

I-Access Investors

IDealing

IFC Markets

IG

InstaForex

Interactive Brokers

Intregal Forex

InterTrader

IronFX

Marex Spectron

MF Global

MFX Broker

MRC Markets

Oanda Corporation

OptionsXpress

Pepperstone

Plus 500

Saxo Bank

Spreadex

Sucden Financial

TeleTrade

TFI Markets

Thinkorswim

Varengold

Wizetrade

Worldspreads

XM.com

X-Trade Brokers

Zulu Trade

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) under which payments are to be made between the parties.[24][33] The most
common underlying assets include commodities, stocks, bonds, interest rates and currencies, but
they can also be other derivatives, which adds another layer of complexity to proper valuation. The
components of a firm's capital structure, 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 conditionally
stochastically and discounted to present value. The market risk inherent in the underlying asset is
attached to the financial derivative through contractual agreements and hence can be traded
separately.[34] The underlying asset does not have to be acquired. Derivatives therefore allow the
breakup of ownership and participation in the market value of an asset. This also provides a
considerable amount of freedom regarding the contract design. That contractual freedom allows 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.[34]
There are two groups of derivative contracts: the privately traded over-the-counter (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 exchanges 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.[35] 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 derivatives, interest rate derivatives, commodity
derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or overthe-counter); 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 caps) 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" 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 DoddFrank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many

rule-making details of regulatory oversight to theCommodity Futures Trading Commission (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 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. [36] However, these are
"notional" values, and some economists say that this value greatly exaggerates 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 much lower, at $21
trillion. The credit risk equivalent of the derivative contracts was estimated at $3.3 trillion. [37]
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, [38] and the total
current value of the U.S. stock market is an estimated $23 trillion. [39] The world annual Gross
Domestic Product is about $65 trillion.[40]
And for one type of derivative at least, 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 referred to in his famous 2002 speech in which he warned
against "weapons of financial mass destruction." CDS notional value in early 2012 amounted to
$25.5 trillion, down from $55 trillion in 2008.[41]

Usage
Derivatives are used for the following:

Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value
moves in the opposite direction to their underlying position and cancels part or all of it out [42][43]

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)[44]

Provide leverage (or gearing), such that a small movement in the underlying value can cause
a large difference in the value of the derivative[45]

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 allocations between different asset classes 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 LIBORrate, while avoiding paying capital gains tax and keeping the
stock.

Mechanics and Valuation Basics

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 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
Main article: Hedge (finance)
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to
another. For example, awheat farmer and a miller could sign a futures contract to exchange a
specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a
future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of
wheat. However, there is still the risk that no wheat will be available because of events unspecified
by the contract, such as the weather, or not that one party will renege on the contract. Although a

third party, called aclearing house, insures a futures contract, not all derivatives are insured against
counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they
sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price
specified in the contract and acquires the risk that the price of wheat will rise above the price
specified in the contract (thereby losing additional income that he could have earned). The miller, on
the other hand, acquires the risk that the price of wheat will fall below the price specified in the
contract (thereby paying more in the future than he otherwise would have) and reduces the risk that
the price of wheat will rise above the price specified in the contract. In this sense, one party is the
insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another
type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond
that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures
contract. The individual or institution has access to the asset for a specified amount of time, and can
then sell it in the future at a specified price according to the futures contract. Of course, this allows
the individual or institution the benefit of holding the asset, while reducing the risk that the future
selling price will deviate unexpectedly from the market's current assessment of the future value of
the asset.

Derivatives traders at the Chicago Board of Trade

Derivatives trading of this kind may serve the financial interests of certain particular businesses.
[46]

For example, a corporation borrows a large sum of money at a specific interest rate. [47] 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 (FRA), which is a
contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[48] 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 and arbitrage

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,

betting that the party seeking insurance will be wrong about the future value of the underlying asset.
Speculators look to buy an asset in the future at a low price according to a derivative contract when
the future market price is high, or to sell an asset in the future at a high price according to a
derivative contract when the future market price is less.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying
price of an asset falls below the price specified in a futures contract to sell the asset.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a
trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a
combination of poor judgment, lack of oversight by the bank's management and regulators, and
unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted
the centuries-old institution.[49]

Proportion Used for Hedging and Speculation

The true proportion of derivatives contracts used for hedging purposes is unknown [50] (and perhaps
unknowable), but it appears to be relatively small. [51][52] Also, derivatives contracts account for only 3
6% of the median firms' total currency and interest rate exposure. [53] Nonetheless, we know that
many firms' derivatives activities have at least some speculative component for a variety of reasons.
[53]

Types

OTC and exchange-traded

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

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements,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 funds. Reporting of OTC amounts is difficult because trades can occur in private,
without activity being visible on any exchange.

According to the Bank for International Settlements, who first surveyed OTC derivatives in 1995,
[54]

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)."[54] 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).[55] 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, like an
ordinary contract, since each counter-party relies on the other to perform.

Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market
where individuals trade standardized contracts that have been defined by the exchange. [24] 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[56] derivatives
exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index
Futures & Options), Eurex (which lists a wide range of European products such as interest rate
& index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile
Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile
Exchange). According to BIS, the combined turnover in the world's derivatives exchanges
totaled USD 344 trillion during Q4 2005. By December 2007 the Bank for International
Settlements reported[54] that "derivatives traded on exchanges surged 27% to a record $681
trillion."[54]

Common derivative contract types

Some of the common variants of derivative contracts are as follows:
1. Forwards: A tailored contract between two parties, where payment takes place at a specific
time in the future at today's pre-determined price.
2. Futures: are 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.
3. Options are contracts that give the owner the right, but not the obligation, to buy (in the case
of a call option) or sell (in the case of a put option) an asset. The price at which the sale
takes place is known as the strike price, and is specified at the time the parties enter into the
option. The option contract also specifies a maturity date. In the case of a European option,

the owner has the right to require the sale to take place on (but not before) the maturity
date; in the case of an American option, the owner can require the sale to take place at any
time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction. Options are of two types: call
option and put option. The buyer of a Call option has a right to buy a certain quantity of the
underlying asset, at a specified price on or before a given date in the future, he however has
no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option has the
right to sell a certain quantity of an underlying asset, at a specified price on or before a given
date in the future, he however has no obligation whatsoever to carry out this right.
4. Binary options are contracts that provide the owner with an all-or-nothing profit profile.
5. Warrants: Apart from the commonly used short-dated options which have a maximum
maturity period of 1 year, there exists certain long-dated options as well, known as Warrant
(finance). These are generally traded over-the-counter.
6. Swaps are contracts to exchange cash (flows) on or before a specified future date based on
the underlying value of currencies exchange rates, bonds/interest rates, commodities
exchange, stocks or other assets. Another term which is commonly associated to Swap
is Swaption which is basically an option on the forward Swap. Similar to a Call and Put
option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one
hand, in case of a receiver Swaption there is an option wherein you can receive fixed and
pay floating, a payer swaption on the other hand is an option to pay fixed and receive
floating.
Swaps can basically be categorized into two types:

Interest rate swap: These basically necessitate swapping only interest associated cash
flows in the same currency, between two parties.

Currency swap: In this kind of swapping, the cash flow between the two parties includes
both principal and interest. Also, the money which is being swapped is in different
currency for both parties.[57]

Some common examples of these derivatives are the following:

CONTRACT TYPES

UNDERLYING
Exchangetraded
futures

DJIA Index
Equity

future
Single-stock
future

Exchangetraded options

OTC swap

OTC forward

Option
on DJIA Index
future

Back-to-back
Equity swap

Single-share

Repurchase
agreement

option

OTC option

Stock option
Warrant
Turbo
warrant

Interest rate
Eurodollar
Interest rate

future
Euribor future

Option on

cap and

Eurodollar future

Interest rate

Forward rate

floor

Option on

swap

agreement

Swaption

Euribor future

Basis swap
Bond option

Credit
Credit

Bond future

Option on Bond

default swap

Repurchase

future

Total return

agreement

swap

Foreign
exchange

Commodity

Credit
default
option

Currency

Option on

Currency

Currency

Currency

future

currency future

swap

forward

option

WTI crude oil

Weather

Commodity

futures

derivative

swap

Iron ore
forward
contract

Gold option

Economic function of the derivative market[edit]

Some of the salient economic functions of the derivative market include:
1. Prices in a structured derivative market 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.
2. The derivatives market reallocates risk from the people who prefer risk aversion to the
people who have an appetite for risk.
3. The intrinsic nature of derivatives market associates them to the underlying Spot
market. 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.
4. 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 can be controlled, resulting in a more meticulous
environment.
5. 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.[58]
In a nutshell, there is a substantial increase in savings and investment in the long run due to
augmented activities by derivative Market participant.[59]

Valuation

Total world derivatives from 1998 to 2007[60] compared to total world wealth in the year 2000[61]

Market and arbitrage-free prices[edit]

Two common measures of value are:

Market price, i.e. the price at which traders are willing to buy or sell the contract

Arbitrage-free price, meaning that no risk-free profits can be made by trading in these
contracts (see rational pricing)

Determining the market price[edit]

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[edit]

See List of finance topics# Derivatives pricing.
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. 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 thestochastic process of the price of the underlying asset is
often crucial. A key equation for the theoretical valuation of optionsis the BlackScholes
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).[62] 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).

Criticisms
Derivatives are often subject to the following criticisms:

Hidden tail risk[edit]

According to Raghuram Rajan, a former chief economist of the International Monetary
Fund (IMF), "... it may well be that the managers of these firms [investment funds] have
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."[63]

Risks[edit]
See also: List of trading losses
The use of derivatives can result in large losses because of the use of leverage, or
borrowing. Derivatives allow investors to earn large returns from small movements in the
underlying asset's price. However, investors could lose large amounts if the price of the
underlying moves against them significantly. There have been several instances of massive
losses in derivative markets, such as the following:

American International Group (AIG) lost more than US$18 billion through a subsidiary
over the preceding three quarters on credit default swaps (CDSs).[64] The United
States Federal Reserve Bank 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. [65]

The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of
futures contracts.

The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural
gas in September 2006 when the price plummeted.

The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.

The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994
by Metallgesellschaft AG.[66]

The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[67]

UBS AG, Switzerland's biggest bank, suffered a $2 billion loss through unauthorized
trading discovered in September 2011.[68]
This comes to a staggering $39.5 billion, the majority in the last decade after
the Commodity Futures Modernization Act of 2000 was passed.

Counter party risk

Some derivatives (especially swaps) expose investors to counterparty risk, 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.

Large notional value

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 in Berkshire Hathaway'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 indicator.(See Berkshire Hathaway Annual Report for 2002)

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.
[69]

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.
[69]

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.
[69][70]

In the context of a 2010 examination of the ICE Trust, an industry self-regulatory

body, Gary Gensler, the chairman of theCommodity Futures Trading Commission which
regulates most derivatives, was quoted saying that the derivatives marketplace as it
functions now "adds up to higher costs to all Americans." More oversight of the banks in
this market is needed, he also said. Additionally, the report said, "[t]he Department of
Justice is looking into derivatives, too. The department's antitrust unit is actively
investigating 'the possibility of anticompetitive practices in the credit derivatives clearing,
trading and information services industries,' according to a department
spokeswoman."[71]
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. [72] 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 DoddFrank Wall Street Reform
and Consumer Protection Act comes into effect. The law mandated the clearing of
certain swaps at registered exchanges and imposed various restrictions on derivatives.
To implement Dodd-Frank, the 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 whose progress is ongoing.[73]
In the U.S., by February 2012 the combined effort of the SEC and CFTC had produced
over 70 proposed and final derivatives rules.[74] 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.[74] SEC Chairman Mary Schapiro opined: "At the end of the day, it probably
does not make sense to harmonize everything [between the SEC and CFTC rules]
because some of these products are quite different and certainly the market structures
are quite different."[75] 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. [76] The two rules are not completely
harmonized with the requirements with CFTC requirements.

Country leaders at the 2009 G-20 Pittsburgh summit

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 in September 2009.[77] 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 opportunities, and fostering a level playing field for market participants.
[77]

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.[77] 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.[77]

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.[78]

Reporting
Mandatory reporting regulations are being finalized in a number of countries, such
as Dodd Frank Act in the US, theEuropean Market Infrastructure Regulations (EMIR) in
Europe, as well as regulations in Hong Kong, Japan, Singapore, Canada, and other
countries.[79] 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.[79]
DTCC, through its "Global Trade Repository" (GTR) service, manages global trade
repositories for interest rates, and commodities, foreign exchange, credit, and equity
derivatives.[79] 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. [79] It
covers cleared and uncleared OTC derivatives products, whether or not a trade is
electronically processed or bespoke.[79][80][81]

Glossary

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.

Counterparty: The legal and financial term for the other party in a financial
transaction.

Credit derivative: A contract that transfers credit risk from a protection buyer to a
credit protection seller. Credit derivative products can take many forms, such
as credit default swaps, credit linked notes and total return swaps.

Derivative: A financial contract whose value is derived from the performance of

assets, interest rates, currency exchange rates, or indexes. Derivative transactions
include a wide assortment of financial contracts including structured debt obligations
and deposits, swaps, futures, options, caps, floors, collars, forwards and various
combinations thereof.

Exchange-traded derivative contracts: Standardized derivative contracts

(e.g., futures contracts and options) that are transacted on an organized futures
exchange.

[Gross negative fair value: The sum of the fair values of contracts where the bank
owes money to its counter-parties, without taking into account netting. This
represents the maximum losses the bank's counter-parties would incur if the bank
defaults and there is no netting of contracts, and no bank collateral was held by the
counter-parties.

Gross positive fair value: The sum total of the fair values of contracts where the
bank is owed money by its counter-parties, without taking into account netting. This
represents the maximum losses a bank could incur if all its counter-parties default
and there is no netting of contracts, and the bank holds no counter-party collateral.

High-risk mortgage securities: Securities where the price or expected average life is
highly sensitive to interest rate changes, as determined by the U.S. Federal
Financial Institutions Examination Council policy statement on high-risk mortgage
securities.

Notional amount: The nominal or face amount that is used to calculate payments
made on swaps and other risk management products. This amount generally does
not change hands and is thus referred to as notional.

Over-the-counter (OTC) derivative contracts: Privately negotiated derivative

contracts that are transacted off organized futures exchanges.

Structured notes: Non-mortgage-backed debt securities, whose cash flow

characteristics depend on one or more indices and / or have embedded forwards or
options.

Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of
common shareholders equity, perpetual preferred shareholders equity with
noncumulative dividends, retained earnings, and minority interests in the equity
accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt,
intermediate-term preferred stock, cumulative and long-term preferred stock, and a
portion of a bank's allowance for loan and lease losses.

Financial derivative trading companies

Alpari Group

Anyoption

Banc de Binary

Cantor Fitzgerald

CitiFXPro

City Index Group

CMC Markets

Currenex

DBF

EToro

ETX Capital

Finspreads

First Prudential Markets

FXCM

FXdirekt Bank

FXOpen

FXPro

Gain Capital

Henyep

Hirose Financial UK Ltd.

HXPM Gold

I-Access Investors

IDealing

IG Group

InstaForex

Interactive Brokers

InterTrader

Marex Spectron

MF Global

MRC Markets

Oanda Corporation

Options press

Pepper stone

Plus 500

Saxo Bank

Spread Co.

Spreadex

Sucden Financial

TeleTrade

TFI Markets

Thinkorswim

Varen Gold

Wizetrade

Worldspreads

X-Trade Brokers

Zulu Trade