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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. To learn more: www.isda.org -------------------------------------------------------------------------------------------------------------------------------------------- Best Alternative Investment Books ---------------------------------------------------------------------------------------------------------- |
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