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Financial Derivatives
According to the Report to Congressional Committees from the United
States General Accounting Office, November 1996,
derivatives are globally used financial
products that essentially unbundle and transfer risks from entities
less able or willing to manage them to those more willing or able to
do so.
The general types of risk
associated with derivatives—credit, market, legal, and
operations—exist for many financial activities.
The values
of derivatives are based on, or derived from, the value of an
underlying asset, reference rate, or index—called the underlying.
Common types of underlying assets are
stocks, bonds, and physical commodities, such
as wheat, oil, and lumber.
An example of an underlying reference rate is the interest rate
on the 3-month U.S. Treasury bill.
An example of an
underlying index is the Standard & Poor’s 500 Index, which measures
the performance of 500 common stocks.
Derivatives include customized and
standardized contracts. Some derivatives are customized contracts
between parties (also called counterparties) that include one or
more negotiated terms in addition to price.
Negotiated terms
can include the quality and quantity of the underlying, time and
place of delivery, and method of payment.
Other derivatives are
standardized contracts whose terms are fixed—except for price, which
the market determines.
Derivatives can be
privately negotiated by the parties; these are called
over-the-counter (OTC) derivatives.
Derivatives also can be
traded through central locations, called organized exchanges, where
buyers and sellers or their representatives meet to determine
derivatives prices; these are called exchange-traded derivatives.
Derivative products include forwards, futures, options, and
swaps. Forwards, futures, and options are typically used to hedge or
to speculate.
Swaps are typically used to hedge or to
obtain more desirable financing. All derivative products can be
combined to create more complex derivatives, called hybrid
derivatives.
Forwards and futures are contracts that obligate the holder to buy
or sell a specific underlying at a specified price, quantity, and
date in the future.
Forwards are commercial, private
contracts for the delivery of a commodity where delivery is deferred
for convenience.
Futures are usually standardized contracts
traded on organized exchanges.
Option contracts, which can
be either customized and privately negotiated or standardized, give
the purchaser the right to buy (call option) or sell (put option) a
specified quantity of a commodity or financial asset at a particular
price (the exercise price) on or before a certain future date
Swaps are generally OTC agreements between counterparties to make
periodic payments to each other for a stated time.
Some swaps are now exchange traded.
Derivatives market participants include end-users and dealers.
End-users include banks, securities firms, insurance companies,
governments, mutual and pension funds, and commercial entities
worldwide.
Certain institutions that use derivatives also act as dealers by
quoting prices to, buying derivatives from, and selling derivatives
to end-users and other dealers. They also develop customized
derivative products for their clients.
Market participants
can use derivatives to protect against adverse changes in the values
of assets or liabilities, called hedging.
Hedgers try to
protect themselves from market risk, which is the exposure to
financial loss caused by adverse changes in the values of assets or
liabilities.
They protect themselves by
entering into derivatives transactions whose values are expected to
change in the opposite direction as the values of their assets or
liabilities.
For example, a hedger can protect asset values
through derivatives transactions that increase in value as the asset
values decline.
The
increases in value of the derivatives
contracts (profits) will offset, or hedge, the decrease in values of
the assets (losses).
In
contrast, market participants can also use derivatives to take on
risk in an attempt to profit from changes in the values of
derivatives or their underlyings, called speculating.
Rather than purchasing the underlying, speculators can use
derivatives to attempt to profit by anticipating movements in market
rates and prices.
As
speculators enter into transactions with hedgers and other
speculators, they provide liquidity to the derivatives markets,
thereby helping to ensure that high volumes of trading can occur
without significantly affecting prices.
Derivatives can be more cost-effective for market participants
than transactions in the underlying cash markets because of the
reduced transaction costs and the leverage that derivatives provide.
For example, instead of
buying or selling $100,000 worth of U.S. Treasury bonds, a market
participant can realize the benefits of buying or selling the same
amount of bonds by using a derivatives contract and posting a
deposit, called a margin, of only about $1,500, or 1.5 percent of
the face amount of the bonds.
Likewise, a
market participant can achieve a result similar to buying or selling
all of the stocks in the Standard & Poor’s 500 Index by buying or
selling a derivatives contract on this index for as little as 5 to
10 percent of the cost of the underlying stocks.
To learn more: http://www.gao.gov/archive/1997/g197008.pdf
According to the International Swaps and Derivatives Association
(ISDA), a derivative is a risk-shifting agreement, the value of
which is derived from the value of an underlying asset.
The
underlying asset could be a
physical commodity, an interest rate, a company’s stock, a stock
index, a currency, or virtually any other tradable instrument upon
which two parties can agree.
Derivatives fall into two
categories.
One consists of customized,
privately negotiated derivatives, which are known generically as
over-the-counter (OTC) derivatives or, even more generically, as
swaps.
The other category consists of
standardized, exchange-traded derivatives, known generically as
futures. In addition, there are various types of product within each
of the two categories as described below.
The terms of a futures
contract—including delivery places and dates, volume, technical
specifications, and trading and credit procedures—are standardized
for each type of contract.
For swaps, the same characteristics are subject to negotiation by
the parties to the contracts.
Futures contracts are always traded
on an exchange, while swaps are traded on a bilateral basis.
Forward contracts - A forward is a customized, privately negotiated
agreement between two parties to exchange an asset or cash flows at
a specified future date at a price agreed on the trade date.
Entering a forward contract typically does not require the payment
of a fee.
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