Derivative (finance) In finance, a derivative is a contract that derives its value mented as inverse. Hence, specifically the market price from the performance of an underlying entity. This un- risk of the underlying asset can be controlled in almost derlying entity can be an asset, index, or interest rate, every situation.[6] [1][2] and is often simply called the "underlying". Deriva- There are two groups of derivative contracts: the pri- tives can be used for a number of purposes, including vately traded over-the-counter (OTC) derivatives such as insuring against price movements (hedging), increasing swaps that do not go through an exchange or other inter- exposure to price movements for speculation or getting [3] mediary, and exchange-traded derivatives (ETD) that are access to otherwise hard-to-trade assets or markets. traded through specialized derivatives exchanges or other Some of the more common derivatives include forwards, exchanges. futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default Derivatives are more common in the modern era, but their swaps. Most derivatives are traded over-the-counter (off- origins trace back several centuries. One of the oldest exchange) or on an exchange such as the Bombay Stock derivatives is rice futures, which have been traded on the Exchange, while most insurance contracts have devel- Dojima Rice Exchange since the eighteenth century.[7] oped into a separate industry. Derivatives are one of the Derivatives are broadly categorized by the relationship three main categories of financial instruments, the other between the underlying asset and the derivative (such two being stocks (i.e., equities or shares) and debt (i.e., as forward, option, swap); the type of underlying as- bonds and mortgages). set (such as equity derivatives, foreign exchange deriva- tives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay- 1 Basics off profile. Derivatives may broadly be categorized as “lock” or “op- Derivatives are contracts between two parties that specify tion” products. Lock products (such as swaps, futures, conditions (especially the dates, resulting values and def- or forwards) obligate the contractual parties to the terms initions of the underlying variables, the parties’ contrac- over the life of the contract. Option products (such as tual obligations, and the notional amount) under which interest rate caps) provide the buyer the right, but not the payments are to be made between the parties.[4][5] The obligation to enter the contract under the terms specified. most common underlying assets include commodities, Derivatives can be used either for risk management (i.e. stocks, bonds, interest rates and currencies, but they can to “hedge” by providing offsetting compensation in case also be other derivatives, which adds another layer of of an undesired event, a kind of “insurance”) or for spec- complexity to proper valuation. The components of a ulation (i.e. making a financial “bet”). This distinction is firm’s capital structure, e.g., bonds and stock, can also important because the former is a prudent aspect of op- be considered derivatives, more precisely options, with erations and financial management for many firms across the underlying being the firm’s assets, but this is unusual many industries; the latter offers managers and investors outside of technical contexts. a risky opportunity to increase profit, which may not be From the economic point of view, financial derivatives properly disclosed to stakeholders. are cash flows, that are conditionally stochastically and Along with many other financial products and services, discounted to present value. The market risk inherent in derivatives reform is an element of the Dodd–Frank Wall the underlying asset is attached to the financial derivative Street Reform and Consumer Protection Act of 2010. through contractual agreements and hence can be traded The Act delegated many rule-making details of regula- separately.[6] The underlying asset does not have to be ac- tory oversight to the Commodity Futures Trading Com- quired. Derivatives therefore allow the breakup of own- mission (CFTC) and those details are not finalized nor ership and participation in the market value of an asset. fully implemented as of late 2012. This also provides a considerable amount of freedom re- garding the contract design. That contractual freedom al- lows to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the par- ticipation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or imple- 1 2 3 USAGE 2 Size of market • Switch asset allocations between different asset classes without disturbing the underlying assets, as To give an idea of the size of the derivative market, The part of transition management Economist has reported that as of June 2011, the over-the- • Avoid paying taxes. For example, an equity swap counter (OTC) derivatives market amounted to approxi- allows an investor to receive steady payments, e.g. mately $700 trillion, and the size of the market traded based on LIBOR rate, while avoiding paying capital on exchanges totaled an additional $83 trillion.[8] How- gains tax and keeping the stock. ever, 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 3.1 Mechanics and Valuation Basics example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion, the value of the market was esti- Lock products are theoretically valued at zero at the time mated much lower, at $21 trillion. The credit risk equiv- of execution and thus do not typically require an up-front alent of the derivative contracts was estimated at $3.3 [9] exchange between the parties. Based upon movements in trillion. the underlying asset over time, however, the value of the Still, even these scaled down figures represent huge contract will fluctuate, and the derivative may be either amounts of money. For perspective, the budget for total an asset (i.e. "in the money") or a liability (i.e. "out of expenditure of the United States government during 2012 the money") at different points throughout its life. Im- was $3.5 trillion,[10] and the total current value of the U.S. portantly, either party is therefore exposed to the credit stock market is an estimated $23 trillion.[11] The world quality of its counterparty and is interested in protecting annual Gross Domestic Product is about $65 trillion.[12] itself in an event of default. And for one type of derivative at least, Credit Default Option products have immediate value at the outset be- Swaps (CDS), for which the inherent risk is considered cause they provide specified protection (intrinsic value) high, the higher, nominal value, remains relevant. It was over a given time period (time value). One common form this type of derivative that investment magnate Warren of option product familiar to many consumers is insur- Buffett referred to in his famous 2002 speech in which he ance for homes and automobiles. The insured would pay warned against “weapons of financial mass destruction.” more for a policy with greater liability protections (in- CDS notional value in early 2012 amounted to $25.5 tril- trinsic value) and one that extends for a year rather than lion, down from $55 trillion in 2008.[13] six months (time value). Because of the immediate op- tion 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 3 Usage change over time while its time value deteriorates steadily until the contract expires. An important difference be- Derivatives are used for the following: tween a lock product is that, after the initial exchange, the option purchaser has no further liability to its coun- terparty; upon maturity, the purchaser will execute the • Hedge or mitigate risk in the underlying, by entering option if it has positive value (i.e. if it is “in the money”) into a derivative contract whose value moves in the or expire at no cost (other than to the initial premium) opposite direction to their underlying position and (i.e. if the option is “out of the money”). cancels part or all of it out[14][15] • Create option ability where the value of the deriva- 3.2 Hedging tive is linked to a specific condition or event (e.g., the underlying reaching a specific price level) Main article: Hedge (finance) • Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather Derivatives allow risk related to the price of the under- derivatives)[16] lying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a • Provide leverage (or gearing), such that a small futures contract to exchange a specified amount of cash movement in the underlying value can cause a large for a specified amount of wheat in the future. Both parties difference in the value of the derivative[17] have reduced a future risk: for the wheat farmer, the un- certainty of the price, and for the miller, the availability of • Speculate and make a profit if the value of the under- wheat. However, there is still the risk that no wheat will lying asset moves the way they expect (e.g. moves in be available because of events unspecified by the contract, a given direction, stays in or out of a specified range, such as the weather, or that one party will renege on the reaches a certain level) contract. Although a third party, called a clearing house, 3.3 Speculation and arbitrage 3 insures a futures contract, not all derivatives are insured to reduce the uncertainty concerning the rate increase and against counter-party risk.