Katana VentraIP

Derivative (finance)

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 simply 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]

This article is about the term as used in finance. For the calculus term, see Derivative. For other uses, see Derivative (disambiguation).

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 (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, 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 (i.e., bonds and mortgages). The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange.[4] However, Aristotle did not define this arrangement as a derivative but as a monopoly (Aristotle's Politics, Book I, Chapter XI). Bucket shops, outlawed in 1936 in the US, are a more recent historical example.

Size of market[edit]

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.[9] For the fourth quarter 2017 the European Securities Market Authority estimated the size of European derivatives market at a size of €660 trillion with 74 million outstanding contracts.[10]


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.[11]


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,[12] and the total current value of the U.S. stock market is an estimated $23 trillion.[13] Meanwhile, the global annual Gross Domestic Product is about $65 trillion.[14]


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 referred to in his famous 2002 speech in which he warned against "financial weapons of mass destruction".[15] CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.[16]

or to 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[17][18]

Hedge

Create ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)

option

Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., )[19]

weather derivatives

Provide (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative[20]

leverage

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)

Speculate

Switch between different asset classes without disturbing the underlying assets, as part of transition management

asset allocations

Avoid paying taxes. For example, an allows an investor to receive steady payments, e.g. based on SONIA rate, while avoiding paying capital gains tax and keeping the stock.

equity swap

For purpose, allowing a riskless profit by simultaneously entering into transactions into two or more markets.[21]

arbitraging

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 expected value of that difference at expiration.

discounted

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

Market price

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

Arbitrage

: 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.

Bilateral netting

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

Counterparty

: 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.

Credit derivative

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.

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

Exchange-traded derivative contracts

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. policy statement on high-risk mortgage securities.

Federal Financial Institutions Examination Council

: 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.

Notional amount

(OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges.

Over-the-counter

: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and / or have embedded forwards or options.

Structured notes

Total risk-based capital: The sum of 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.

tier 1

Söhnke M. Bartram; Brown, Gregory W.; Conrad, Jennifer C. (August 2011). (PDF). Journal of Financial and Quantitative Analysis. 46 (4): 967–999. doi:10.1017/s0022109011000275. S2CID 3945906. SSRN 1550942.

"The Effects of Derivatives on Firm Risk and Value"

Söhnke M. Bartram; Kevin Aretz (Winter 2010). (PDF). Journal of Financial Research. 33 (4): 317–371. CiteSeerX 10.1.1.534.728. doi:10.1111/j.1475-6803.2010.01278.x. S2CID 20087872. SSRN 1354149.

"Corporate Hedging and Shareholder Value"

Söhnke M. Bartram; Gregory W. Brown; Frank R. Fehle (Spring 2009). "International Evidence on Financial Derivatives Usage". Financial Management. 38 (1): 185–206. :10.1111/j.1755-053x.2009.01033.x. SSRN 471245.

doi

Lins Lemke (2013–2014). Soft Dollars and Other Trading Activities. Thomson West.

Institute for Financial Markets (2011). Futures and Options (2nd ed.). Washington, D.C.: Institute for Financial Markets.  978-0-615-35082-0.

ISBN

John C. Hull (2011). Options, Futures and Other Derivatives (8th ed.). Harlow: Pearson Education.  978-0-13-260460-4.

ISBN

Michael Durbin (2011). All About Derivatives (2nd ed.). New York: McGraw-Hill.  978-0-07-174351-8.

ISBN

Mehraj Mattoo (1997). Structured Derivatives: New Tools for Investment Management: A Handbook of Structuring, Pricing & Investor Applications. London: Financial Times.  978-0-273-61120-2.

ISBN

Andrei N. Soklakov (2013). "Elasticity Theory of Structuring". :1304.7535 [q-fin.GN].

arXiv

Andrei N. Soklakov (2013). "Deriving Derivatives".  2262941.

SSRN

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

(Federal Reserve Bank of Chicago)

Understanding Derivatives: Markets and Infrastructure

BBC News

"Derivatives simple guide"

. Archived October 27, 2020, at the Wayback Machine. CFA Institute.

Investment-foundations: Derivatives

(archived 19 February 2014)

"European Union proposals on derivatives regulation – 2008 onwards"

PwC Financial Services Regulatory Practice (December 2013)

" Derivatives Regulatory Roulette"