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A derivative is a financial instrument that derives or gets it value some real good or stock. It is in its most basic form simply a conbetween two parties to exchange value based on the action of a

good or service. Typically, the seller receives money in exchange fagreement to purchase or sell some good or service at some specfuture date.

The largest appeal of derivatives is that they offer some degreleverage. Leverage is a financial term that refers to the multiplicthat happens when a small amount of money is used to control anof much larger value. A mortgage is the most common form

leverage. For a small amount of money and taking on the obligationmortgage, a person gains control of a property of much larger vthan the small amount of money that has exchanged hands.

In finance, a derivative is a financial instrument (or, more simply, agreement between two parties) that has a value, based on the expefuture price movements of the asset to which it is linked—called thunderlying asset— [1] such as a share or a currency. There are many

kinds of derivatives, with the most common being swaps, futures, aoptions. Derivatives are a form of alternative investment.

A derivative is not a stand-alone asset, since it has no value of its owHowever, more common types of derivatives have been traded on

markets before their expiration date as if they were assets. Amothe oldest of these are rice futures, which have been traded on theDojima Rice Exchange since the eighteenth century.[2]

Derivatives are usually broadly categorized by:

• the relationship between the underlying asset and the derivativ(e.g., forward, option, swap);

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• the type of underlying asset (e.g., equity derivatives, foreignexchange derivatives, interest rate derivatives, commodity derivativor credit derivatives);•

the market in which they trade (e.g., exchange-traded or over-tcounter ); and• their pay-off profile.

Another arbitrary distinction is between:[3]

• vanilla derivatives (simple and more common); and• exotic derivatives (more complicated and specialized).

Contents

[hide]

• 1 Uses o 1.1 Hedging o 1.2 Speculation and arbitrage • 2 Types of derivatives o 2.1 OTC and exchange-traded o 2.2 Common derivative contract types o 2.3 Examples • 3 Valuation o 3.1 Market and arbitrage-free prices o 3.2 Determining the market price o 3.3 Determining the arbitrage-free price 

• 4 Criticism o 4.1 Possible large losses o 4.2 Counter-party risk  o 4.3 Large notional value o 4.4 Leverage of an economy's debt 

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• 5 Benefits • 6 Government regulation • 7 Definitions •

8 See also • 9 References • 10 Further reading 

• 11 External links 

[edit] Uses

Derivatives are used by investors to:

• provide leverage (or gearing), such that a small movement in tunderlying value can cause a large difference in the value of thederivative;• speculate and make a profit if the value of the underlying assetmoves the way they expect (e.g., moves in a given direction, stays iout of a specified range, reaches a certain level);•

hedge  or mitigate risk in the underlying, by entering into aderivative contract whose value moves in the opposite direction to tunderlying position and cancels part or all of it out;• obtain exposure to the underlying where it is not possible to train the underlying (e.g., weather derivatives);• create option ability where the value of the derivative is linkedspecific condition or event (e.g., the underlying reaching a specific level).

[edit] Hedging

This section does not cite any references or sources.Please help improve this article by adding citations to reliable sou

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Unsourced material may be challenged and removed. (October 20

Derivatives can be considered as providing a form of insurance in

hedging, which is itself a technique that attempts to reduce risk .Derivatives allow risk related to the price of the underlying asset totransferred from one party to another. For example, a wheat farmera miller could sign a futures contract to exchange a specified amouncash for a specified amount of wheat in the future. Both parties havreduced a future risk: for the wheat farmer, the uncertainty of the prand for the miller, the availability of wheat. However, there is still t

risk that no wheat will be available because of events unspecified bcontract, such as the weather, or that one party will renege on thecontract. Although a third party, called a clearing house, insures afutures contract, not all derivatives are insured against counter-partyrisk.

From another perspective, the farmer and the miller both reduce a rand acquire a risk when they sign the futures contract: the farmer 

reduces the risk that the price of wheat will fall below the pricespecified in the contract and acquires the risk that the price of wheawill rise above the price specified in the contract (thereby losingadditional income that he could have earned). The miller, on the othhand, acquires the risk that the price of wheat will fall below the prspecified in the contract (thereby paying more in the future than heotherwise would have) and reduces the risk that the price of wheat w

rise above the price specified in the contract. In this sense, one partythe insurer (risk taker) for one type of risk, and the counter-party is 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 th

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pays dividends, and so on) and sells it using a futures contract. Theindividual or institution has access to the asset for a specified amoutime, and can then sell it in the future at a specified price according

the futures contract. Of course, this allows the individual or institutthe benefit of holding the asset, while reducing the risk that the futuselling price will deviate unexpectedly from the market's currentassessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade.

Derivatives can serve legitimate business purposes. For example, a

corporation borrows a large sum of money at a specific interest rateThe rate of interest on the loan resets every six months. The corporais concerned that the rate of interest may be much higher in six monThe corporation could buy a forward rate agreement (FRA), which contract to pay a fixed rate of interest six months after purchases onnotional amount of money.[5] If the interest rate after six months isabove the contract rate, the seller will pay the difference to thecorporation, or FRA buyer. If the rate is lower, the corporation willthe difference to the seller. The purchase of the FRA serves to reduthe uncertainty concerning the rate increase and stabilize earnings.

[edit] Speculation and arbitrage

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Derivatives can be used to acquire risk, rather than to insure or hedgagainst risk. Thus, some individuals and institutions will enter into derivative contract to speculate on the value of the underlying asset

betting that the party seeking insurance will be wrong about the futuvalue of the underlying asset. Speculators look to buy an asset in thfuture at a low price according to a derivative contract when the futmarket price is high, or to sell an asset in the future at a high priceaccording to a derivative contract when the future market price is lo

Individuals and institutions may also look for arbitrage opportunitiewhen the current buying price of an asset falls below the price spec

in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in1995 when Nick Leeson, a trader at Barings Bank , made poor andunauthorized investments in futures contracts. Through a combinatiof poor judgment, lack of oversight by the bank's management andregulators, and unfortunate events like the Kobe earthquake, Leesonincurred a US$1.3 billion loss that bankrupted the centuries-old

institution.[6]

[edit] Types of derivatives

[edit] OTC and exchange-traded

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

• Over-the-counter  (OTC) derivatives are contracts that are tr(and privately negotiated) directly between two parties, without goithrough an exchange or other intermediary. Products such as swapsforward rate agreements, and exotic options are almost always tradethis way. The OTC derivative market is the largest market for 

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derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up banks and other highly sophisticated parties, such as hedge funds.

Reporting of OTC amounts are difficult because trades can occur inprivate, without activity being visible on any exchange. According the Bank for International Settlements, the total outstanding notionaamount is US$684 trillion (as of June 2008).[7] Of this total notionalamount, 67% are interest rate contracts, 8% are credit default swaps(CDS), 9% are foreign exchange contracts, 2% are commoditycontracts, 1% are equity contracts, and 12% are other. Because OTCderivatives are not traded on an exchange, there is no central counte

party. Therefore, they are subject to counter-party risk, like an ordincontract, since each counter-party relies on the other to perform.

• Exchange-traded derivative contracts  (ETD) are thosederivatives instruments that are traded via specialized derivativesexchanges or other exchanges. A derivatives exchange is a marketwhere individuals trade standardized contracts that have been defin

by the exchange.

[8]

A derivatives exchange acts as an intermediary trelated transactions, and takes Initial margin from both sides of the to act as a guarantee. The world's largest[9] derivatives exchanges (bnumber of transactions) are the Korea Exchange (which lists KOSPIndex Futures & Options), Eurex (which lists a wide range of Europproducts such as interest rate & index products), and CME Group (up of the 2007 merger of the Chicago Mercantile Exchange and theChicago Board of Trade and the 2008 acquisition of the New York 

Mercantile Exchange). According to BIS, the combined turnover inworld's derivatives exchanges totaled USD 344 trillion during Q4 2Some types of derivative instruments also may trade on traditionalexchanges. For instance, hybrid instruments such as convertible bonand/or convertible preferred may be listed on stock or bond exchang

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Also, warrants (or "rights") may be listed on equity exchanges.Performance Rights, Cash xPRTs and various other instruments thaessentially consist of a complex set of options bundled into a simple

package are routinely listed on equity exchanges. Like other derivatthese publicly traded derivatives provide investors access to risk/rewand volatility characteristics that, while related to an underlyingcommodity, nonetheless are distinctive.

[edit] Common derivative contract types

There are three major classes of derivatives:

1. Futures  /Forwards are contracts to buy or sell an asset on or bea future date at a price specified today. A futures contract differs froforward contract in that the futures contract is a standardized contrawritten by a clearing house that operates an exchange where thecontract can be bought and sold, whereas a forward contract is a nostandardized contract written by the parties themselves.2. 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 ofput option) an asset. The price at which the sale takes place is knowthe strike price, and is specified at the time the parties enter into theoption. The option contract also specifies a maturity date. In the casa European option, the owner has the right to require the sale to takplace on (but not before) the maturity date; in the case of an Americoption, the owner can require the sale to take place at any time up tomaturity date. If the owner of the contract exercises this right, thecounter-party has the obligation to carry out the transaction.3. Swaps  are contracts to exchange cash (flows) on or before aspecified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stockother assets.

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More complex derivatives can be created by combining the elementhese basic types. For example, the holder of a swaption has the rigbut not the obligation, to enter into a swap on or before a specified

future date.[edit] Examples

The overall derivatives market has five major classes of underlyingasset:

• interest rate derivatives  (the largest)• foreign exchange derivatives • credit derivatives • equity derivatives • commodity derivatives 

Some common examples of these derivatives are:

UNDERLYING

CONTRACT TYPES

Exchange-traded

futures

Exchange-traded

options OTC swapOTC forwardOTC option

EquityDJIA Index futureSingle-stock future

Option on DJIAfutureSingle-share option

Equity swapBack-to-back Repurchase agreement

Stock optionWarrantTurbo warr ant

Interest rateEurodollar future

Euribor future

Option on Eurodollar future

Option on Euribor future

Interest rate swapForward rate

agreement

Interest rate cap anfloor Swaption

Basis swapBond option

CreditBond futureOption on Bond futureCredit defaultswapTotal r eturn swap

Repurchase agreementCredit default opti

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Foreign

exchangeCurrency futureOption on cur rency futureCurrency swapCurrency f orwardCurrency option

CommodityWTI crude oil futuresWeather derivativesCommodity swapIron ore forward

contract

Gold option

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives • Economic derivatives  that pay off according to economic repo as measured and reported by national statistical agencies• Freight derivatives •

Inflation derivatives • Weather derivatives • Insurance derivatives[citation needed ] • Emissions derivatives  [11] 

[edit] Valuation

Total world derivatives from 1998-2007[12] compared to total worldwealth in the year 2000[13]

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[edit] Market and arbitrage-free prices

Two common measures of value are:

• Market price  , i.e., the price at which traders are willing to buy sell the contract;• Arbitrage  -free price, meaning that no risk-free profits can be mby trading in these contracts; see rational pricing.

[edit] Determining the market price

For exchange-traded derivatives, market price is usually transparen

(often published in real time by the exchange, based on all the currebids and offers placed on that particular contract at any one time).Complications can arise with OTC or floor-traded contracts thoughtrading is handled manually, making it difficult to automaticallybroadcast prices. In particular with OTC contracts, there is no centrexchange to collate and disseminate prices.

[edit] Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is complex, and thare many different variables to consider. Arbitrage-free pricing is acentral topic of financial mathematics. The stochastic process of theprice of the underlying asset is often crucial. A key equation for thetheoretical valuation of options is the Black–Scholes formula, whicbased on the assumption that the cash flows from a European stock

option can be replicated by a continuous buying and selling strategyusing only the stock. A simplified version of this valuation techniquthe binomial options model. OTC represents the biggest challenge iusing models to price derivatives. Since these contracts are not pubtraded, no market price is available to validate the theoretical valuaAnd most of the model's results are input-dependant (meaning the f

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price depends heavily on how we derive the pricing inputs).[14]

Therefore it is common that OTC derivatives are priced by IndepenAgents that both counterparties involved in the deal designate upfro

(when signing the contract).[edit] Criticism

Derivatives are often subject to the following criticisms:

[edit] Possible large losses

See also: List of trading losses

The use of derivatives can result in large losses because of the use oleverage, or borrowing. Derivatives allow investors to earn large refrom small movements in the underlying asset's price. However,investors could lose large amounts if the price of the underlying moagainst them significantly. There have been several instances of malosses in derivative markets, such as:

• The need to recapitalize insurer American InternatioGroup (AIG) with US$85 billion of debt provided by the federal government.[15] An AIG subsidiary had lost more US$18 billion over the preceding three quarters on CreditDefault Swaps (CDS) it had written.[16] It was reported threcapitalization was necessary because further losses werforeseeable over the next few quarters.•

The loss of US$7.2 Billion by Société Générale inJanuary 2008 through mis-use of futures contracts.• The loss of US$6.4 billion in the failed fund AmaranAdvisors, which was long natural gas in September 2006when the price plummeted.

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• The loss of US$4.6 billion in the failed fund Long-TCapital Management in 1998.• The loss of US$1.3 billion equivalent in oil derivativ

1993 and 1994 by Metallgesellschaft AG.

[17]

 • The loss of US$1.2 billion equivalent in equityderivatives in 1995 by Barings Bank .[18] 

[edit] Counter-party risk 

Some derivatives (especially swaps) expose investors to counter-p

risk .

For example, suppose a person wanting a fixed interest rate loan forbusiness, but finding that banks only offer variable rates, swapspayments with another business who wants a variable rate, syntheticreating a fixed rate for the person. However if the second businessgoes bankrupt, it can't pay its variable rate and so the first business lose its fixed rate and will be paying a variable rate again. If interesrates have increased, it is possible that the first business may be

adversely affected, because it may not be prepared to pay the highevariable rate.

Different types of derivatives have different levels of counter-partyFor example, standardized stock options by law require the party atto have a certain amount deposited with the exchange, showing thatthey can pay for any losses; banks that help businesses swap variabfor fixed rates on loans may do credit checks on both parties. Howe

in private agreements between two companies, for example, there mnot be benchmarks for performing due diligence and risk analysis.

[edit] Large notional value

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Derivatives typically have a large notional value. As such, there isdanger that their use could result in losses that the investor would bunable to compensate for. The possibility that this could lead to a ch

reaction ensuing in an economic crisis, has been pointed out by faminvestor Warren Buffett in Berkshire Hathaway's 2002 annual reporBuffett called them 'financial weapons of mass destruction.' Theproblem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the reacapital and equities markets. Investors begin to look at the derivativmarkets to make a decision to buy or sell securities and so what waoriginally meant to be a market to transfer risk now becomes a lead

indicator. (See Berkshire Hathaway Annual Report for 2002)

[edit] Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making iever more difficult for the underlying real economy to service its deobligations, thereby curtailing real economic activity, which can carecession or even depression. In the view of Marriner S. Eccles, U.S

Federal Reserve Chairman from November, 1934 to February, 1948high a level of debt was one of the primary causes of the 1920s-30sGreat Depression. (See Berkshire Hathaway Annual Report for 200

[edit] Benefits

The use of derivatives also has its benefits:

• Derivatives facilitate the buying and selling of risk, and manypeople[who?] consider this to have a positive impact on the economicsystem. Although someone loses money while someone else gainsmoney with a derivative, under normal circumstances, trading in

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derivatives should not adversely affect the economic system becausis not zero sum in utility.• Former Federal Reserve Board chairman Alan Greenspan 

commented in 2003 that he believed that the use of derivatives hassoftened the impact of the economic downturn at the beginning of t21st century.[citation needed ] 

[edit] Government regulation

In the context of a 2010 examination of the ICE Trust, an industry sregulatory body, Gary Gensler , the chairman of the Commodity Fut

Trading Commission which regulates most derivatives, was quotedsaying that the derivatives marketplace as it functions now "adds uphigher costs to all Americans." More oversight of the banks in thismarket is needed, he also said. Additionally, the report said, "[t]heDepartment of Justice is looking into derivatives, too. The departmeantitrust unit is actively investigating 'the possibility of anticompetipractices in the credit derivatives clearing, trading and informationservices industries,' according to a department spokeswoman."[19]

[edit] Definitions

• Bilateral netting  : A legally enforceable arrangement between abank and a counter-party that creates a single legal obligation coverall included individual contracts. This means that a bank’s obligatiothe event of the default or insolvency of one of the parties, would bnet sum of all positive and negative fair values of contracts included

the bilateral netting arrangement.• Credit derivative  : A contract that transfers credit risk from aprotection buyer to a credit protection seller. Credit derivative prodcan take many forms, such as credit default swaps, credit linked notand total return swaps.

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• Derivative: A financial contract whose value is derived from thperformance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of finan

contracts including structured debt obligations and deposits, swaps,futures, options, caps, floors, collars, forwards and variouscombinations thereof.• Exchange-traded derivative contracts  : Standardized derivativecontracts (e.g., futures contracts and options) that are transacted on organized futures exchange.• Gross negative fair value  : The sum of the fair values of contrawhere the bank owes money to its counter-parties, without taking in

account netting. This represents the maximum losses the bank’scounter-parties would incur if the bank defaults and there is no nettof 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, withtaking into account netting. This represents the maximum losses a bcould incur if all its counter-parties default and there is no netting o

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, asdetermined by the FFIEC policy statement on high-risk mortgagesecurities.• Notional amount  : The nominal or face amount that is used tocalculate payments made on swaps and other risk managementproducts. This amount generally does not change hands and is thusreferred to as notional.• Over-the-counter   (OTC) derivative contracts: Privately negotiaderivative contracts that are transacted off organized futures exchan

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• Structured notes  : Non-mortgage-backed debt securities, whosecash flow characteristics depend on one or more indices and / or haembedded forwards or options.•

Total risk-based capital  : The sum of tier 1 plus tier 2 capital. Tcapital consists of common shareholders equity, perpetual preferredshareholders equity with non-cumulative dividends, retained earninand minority interests in the equity accounts of consolidatedsubsidiaries. Tier 2 capital consists of subordinated debt, intermediaterm preferred stock , cumulative and long-term preferred stock, andportion of a bank’s allowance for loan and lease losses.

[edit] See also

Book: Finance

Wikipedia Books are collections of articles that can be downloadedordered in print.

• Dual currency deposit • Forward contract • FX Option 

[edit] References

1.  ̂ McDonald, R.L. (2006) Derivatives markets. Boston:Addison-Wesley2.  ̂ Kaori Suzuki and David Turner (December 10, 2005)."Sensitive politics over Japan's staple crop delays rice futuresplan". The Financial Times. http://www.ft.com/cms/s/0/d9f45d6922-11da-bd30-0000779e2340.html. Retrieved October 23, 23.  ̂ Taylor, Francesca. (2007). Mastering Derivatives MarkPrentice Hall4.  ̂ Chisolm, Derivatives Demystified (Wiley 2004)

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5.  ̂ Chisolm, Derivatives Demystified (Wiley 2004) Notionsum means there is no actual principal.6.  ̂ News.BBC.co.uk , "How Leeson broke the bank - BBC

Economy"7.  ̂ BIS survey: The Bank for International Settlements (BIsemi-annual OTC derivatives statistics report, for end of June2008, shows US$683.7 billion total notional amounts outstandof OTC derivatives with a gross market value of US$20 trillioSee also Prior Period Regular OTC Derivatives Market Statis

8.  ̂ Hull, J.C. (2009). Options, futures, and other derivativeUpper Saddle River, NJ : Pearson/Prentice Hall, c20099.  ̂ Futures and Options Week : According to figures publisin F&O Week 10 October 2005. See also FOW Website.10.  ̂ "Biz.Yahoo.com". Biz.Yahoo.com. 2010-08-23.http://biz.yahoo.com/c/e.html. Retrieved 2010-08-29.11.  ̂ FOW.com, Emissions derivatives, 1 December 200512.  ̂ "Bis.org". Bis.org. 2010-05-07.http://www.bis.org/statistics/derstats.htm. Retrieved 2010-08-2

13.  ̂ "Launch of the WIDER study on The World DistributioHousehold Wealth: 5 December 2006".http://www.wider.unu.edu/events/past-events/2006-events/en_GB/05-12-2006/. Retrieved 9 June 2009.14.  ̂ Boumlouka, Makrem (2009),"Alternatives in OTC PricHedge Funds Review, 10-30-2009.http://www.hedgefundsreview.com/hedge-funds-review/news/1560286/otc-pricing-deal-struck-fitch-solutions-pricing-partners 15.  ̂ Derivatives Counter-party Risk: Lessons from AIG andCredit Crisis 16.  ̂ Kelleher, James B. (2008-09-18). ""Buffett's Time BomGoes Off on Wall Street" by James B. Kelleher of Reuters".

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Reuters.com.http://www.reuters.com/article/newsOne/idUSN183715402008. Retrieved 2010-08-29.

17.  ̂ Edwards, Franklin (1995), "Derivatives Can Be HazardTo Your Health: The Case of Metallgesellschaft", Derivatives

Quarterly (Spring 1995): 8–17,http://www0.gsb.columbia.edu/faculty/fedwards/papers/DerivsCanBeHazardous.pdf  18.  ̂ Whaley, Robert (2006). Derivatives: markets, valuation

and risk management . John Wiley and Sons. p. 506.ISBN 0471786322. http://books.google.com/books?id=Hb7xX

wqiYC&printsec=frontcover&source=gbs_ge_summary_r&ca#v=onepage&q&f=false.19.  ̂ Story, Louise, "A Secretive Banking Elite Rules TradinDerivatives", The New York Times, December 11, 2010 (Decem12, 2010 p. A1 NY ed.). Retrieved 2010-12-12.

[edit] Further reading

• Mehraj Mattoo (1997), Structured Derivatives: New Tools foInvestment Management A Handbook of Structuring, Pricing &Investor Applications (Financial Times) Amazon listing 

[edit] External links

• BBC News - Derivatives simple guide • European Union proposals on derivatives regulation - 2008 

onwards • Derivatives in Africa 

Retrieved from "http://en.wikipedia.org/wiki/Derivative_(finance)"