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Derivative (nance)

In nance, a derivative is a contract that derives its valuefrom the performance of an underlying entity. This un-derlying entity can be an asset, index, or interest rate,and is often simply called the "underlying".[1][2] Deriva-tives can be used for a number of purposes, includinginsuring against price movements (hedging), increasingexposure to price movements for speculation or gettingaccess to otherwise hard-to-trade assets or markets. [3]

Some of the more common derivatives include forwards,futures, options, swaps, and variations of these such as

synthetic collateralized debt obligations and credit defaultswaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Bombay StockExchange, while most insurance contracts have devel-oped into a separate industry. Derivatives are one of thethree main categories of nancial instruments, the othertwo being stocks (i.e., equities or shares) and debt (i.e.,bonds and mortgages).

1 Basics

Derivatives are contracts between two parties that specifyconditions (especially the dates, resulting values and def-initions of the underlying variables, the parties’ contrac-tual obligations, and the notional amount) under whichpayments are to be made between the parties. [4][5] Themost common underlying assets include commodities,stocks, bonds, interest rates and currencies, but they canalso be other derivatives, which adds another layer ofcomplexity to proper valuation. The components of arm’s capital structure, e.g., bonds and stock, can alsobe considered derivatives, more precisely options, withthe underlying being the rm’s assets, but this is unusual

outside of technical contexts.From the economic point of view, nancial derivativesare cash ows, that are conditionally stochastically anddiscounted to present value. The market risk inherent inthe underlying asset is attached to the nancial derivativethrough contractual agreements and hence can be tradedseparately. [6] The underlying asset does not have to be ac-quired. Derivatives therefore allow the breakup of own-ership and participation in the market value of an asset.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 beeffectively weaker, stronger (leverage effect), or imple-

mented as inverse. Hence, specically the market pricerisk of the underlying asset can be controlled in almostevery situation.[6]

There are two groups of derivative contracts: the pri-vately traded over-the-counter (OTC) derivatives such asswaps that do not go through an exchange or other inter-mediary, and exchange-traded derivatives (ETD) that aretraded through specialized derivatives exchanges or otherexchanges.

Derivatives aremore commonin themodern era, but theirorigins trace back several centuries. One of the oldestderivatives is rice futures, which have been traded on theDojima Rice Exchange since the eighteenth century. [7]

Derivatives are broadly categorized by the relationshipbetween the underlying asset and the derivative (suchas forward, option, swap); the type of underlying as-set (such as equity derivatives, foreign exchange deriva-tives, interest rate derivatives, commodity derivatives, orcredit derivatives); the market in which they trade (suchas exchange-traded or over-the-counter ); and their pay-off prole.

Derivatives may broadly be categorized as “lock” or “op-tion” products. Lock products (such as swaps, futures,or forwards) obligate the contractual parties to the termsover the life of the contract. Option products (such asinterest rate caps) provide the buyer the right, but not theobligation to enter the contract under the terms specied.

Derivatives can be used either for risk management (i.e.to “hedge” by providing offsetting compensation in caseof an undesired event, a kind of “insurance”) or for spec-ulation (i.e. making a nancial “bet”). This distinction isimportant because the former is a prudent aspect of op-erations and nancial management for many rms acrossmany industries; the latter offers managers and investorsa risky opportunity to increase prot, which may not beproperly disclosed to stakeholders.

Along with many other nancial products and services,derivatives reform is an element of the Dodd–Frank WallStreet Reform and Consumer Protection Act of 2010.The Act delegated many rule-making details of regula-tory oversight to the Commodity Futures Trading Com-mission (CFTC) and those details are not nalized norfully implemented as of late 2012.

1

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2 3 USAGE

2 Size of market

To give an idea of the size of the derivative market, TheEconomist hasreported that as of June 2011, theover-the-counter (OTC) derivatives market amounted to approxi-mately $700 trillion, and the size of the market tradedon exchanges totaled an additional $83 trillion.[8] How-ever, these are “notional” values, and some economistssay that this value greatly exaggerates the market valueand the true credit risk faced by the parties involved. Forexample, in 2010, while the aggregate of OTC derivativesexceeded $600 trillion, the value of the market was esti-mated much lower, at $21 trillion. The credit risk equiv-alent of the derivative contracts was estimated at $3.3trillion. [9]

Still, even these scaled down gures represent hugeamounts of money. For perspective, the budget for totalexpenditure of the United States government during 2012was$3.5 trillion,[10] andthe totalcurrent valueof the U.S.stock market is an estimated $23 trillion. [11] The worldannual Gross Domestic Product is about $65 trillion.[12]

And for one type of derivative at least, Credit DefaultSwaps (CDS), for which the inherent risk is consideredhigh, the higher, nominal value, remains relevant. It wasthis type of derivative that investment magnate WarrenBuffett referred to in his famous 2002 speech in which hewarned against “weapons of nancial mass destruction.”CDS notional value in early 2012 amounted to $25.5 tril-lion, down from $55 trillion in 2008.[13]

3 Usage

Derivatives are used for the following:

• Hedge or mitigate risk in the underlying, by enteringinto a derivative contract whose value moves in theopposite direction to their underlying position andcancels part or all of it out[14][15]

• Create option ability where the value of the deriva-tive is linked to a specic condition or event (e.g.,the underlying reaching a specic price level)

• Obtain exposure to the underlying where it is notpossible to trade in the underlying (e.g., weatherderivatives)[16]

• Provide leverage (or gearing), such that a smallmovement in the underlying value can cause a largedifference in the value of the derivative[17]

• Speculate andmakea prot if the valueof the under-

lyingasset moves the way they expect (e.g. moves ina given direction, stays in or out of a specied range,reaches a certain level)

• Switch asset allocations between different assetclasses without disturbing the underlying assets, aspart of transition management

• Avoid paying taxes. For example, an equity swapallows an investor to receive steady payments, e.g.

based on LIBOR rate, while avoiding paying capitalgains tax and keeping the stock.

3.1 Mechanics and Valuation Basics

Lock products are theoretically valued at zero at the timeof execution and thus do not typically require an up-frontexchange between the parties. Based upon movements inthe underlying asset over time, however, the value of thecontract will uctuate, and the derivative may be eitheran asset (i.e. "in the money") or a liability (i.e. "out ofthe money") at different points throughout its life. Im-portantly, either party is therefore exposed to the creditquality of its counterparty and is interested in protectingitself in an event of default.

Option products have immediate value at the outset be-cause they provide specied protection ( intrinsic value)over a given time period ( time value). One common formof option product familiar to many consumers is insur-ance for homes and automobiles. The insured would paymore for a policy with greater liability protections (in-trinsic value) and one that extends for a year rather thansix months (time value). Because of the immediate op-tion value, the option purchaser typically pays an up frontpremium. Just like for lock products, movements in theunderlying asset will cause the option’s intrinsic value tochange over time while its time value deteriorates steadilyuntil the contract expires. An important difference be-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 theoption if it has positive value (i.e. if it is “in the money”)or expire at no cost (other than to the initial premium)(i.e. if the option is “out of the money”).

3.2 Hedging

Main article: Hedge (nance)

Derivatives allow risk related to the price of the under-lying asset to be transferred from one party to another.For example, a wheat farmer and a miller could sign afutures contract to exchange a specied amount of cashfor a specied amount of wheat in the future. Both partieshave reduced a future risk: for the wheat farmer, the un-certainty of theprice, andfor themiller, the availability ofwheat. However, there is still the risk that no wheat will

be availablebecause of events unspecied by thecontract,such as the weather, or that one party will renege on thecontract. Although a third party, called a clearing house,

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3.3 Speculation and arbitrage 3

insures a futures contract, not all derivatives are insuredagainst counter-party risk.

From another perspective, the farmer and the miller bothreduce a risk and acquire a risk when they sign the fu-tures contract: the farmer reduces the risk that the price

of wheat will fall below the price specied in the con-tract and acquires the risk that the price of wheat will riseabove the price specied in the contract (thereby losingadditional incomethathe could have earned). The miller,on the other hand, acquires therisk that the price of wheatwill fall below the price specied in the contract (therebypaying more in the future than he otherwise would have)andreduces the risk that the price of wheat will rise abovethe price specied in the contract. In this sense, one partyis the insurer (risk taker) for one type of risk, and thecounter-party is the insurer (risk taker) for another typeof risk.

Hedging also occurs when an individual or institutionbuys an asset (such as a commodity, a bond that hascoupon payments, a stock that pays dividends, and so on)and sells it using a futures contract. The individual orinstitution has access to the asset for a specied amountof time, and can then sell it in the future at a speciedprice according to the futures contract. Of course, thisallows the individual or institution the benet of holdingthe asset, while reducing the risk that the future sellingprice will deviate unexpectedly from the market’s currentassessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade

Derivatives trading of this kind may serve thenancial in-terests of certain particular businesses. [18] For example, acorporation borrows a large sum of money at a specic in-terest rate. [19] The interest rate on the loan reprices everysix months. The corporation is concerned that the rate ofinterest may be much higher in six months. The corpora-tion could buy a forward rate agreement (FRA), which isa contract to pay a xed rate of interest six months afterpurchases on a notional amount of money. [20] If the in-terest rate after six months is above the contract rate, the

seller will pay the difference to the corporation, or FRAbuyer. If the rate is lower, the corporation will pay thedifference to the seller. The purchase of the FRA serves

to reduce the uncertainty concerningtherate increaseandstabilize earnings.

3.3 Speculation and arbitrage

Derivatives can be used to acquire risk, rather than tohedge against risk. Thus, some individuals and institu-tions will enter into a derivative contract to speculate onthe value of the underlying asset, betting that the partyseeking insurance will be wrong about the future valueof the underlying asset. Speculators look to buy an as-set in the future at a low price according to a derivativecontract when the future market price is high, or to sell anasset in the future at a high price according to a derivativecontract when the future market price is less.

Individuals and institutions may also look for arbitrageopportunities, as when the current buying priceofan asset

falls below the price specied in a futures contract to sellthe asset.

Speculative trading in derivatives gained a great deal ofnotoriety in 1995 when Nick Leeson, a trader at BaringsBank, made poor and unauthorized investments in futurescontracts. Througha combination of poor judgment, lackof oversight by the bank’s management and regulators,and unfortunate events like the Kobe earthquake, Lee-son incurred a 1.3 billion USD loss that bankrupted thecenturies-old institution. [21]

3.4 Proportion Used for Hedging andSpeculation

The true proportion of derivatives contracts used forhedging purposes is unknown[22] (and perhaps unknow-able), but it appears to be relatively small.[23][24] Also,derivatives contracts account for only 3–6% of the me-dian rms’ total currency and interest rate exposure.[25]

Nonetheless, we know that many rms’ derivatives activ-ities have at least some speculative component for a vari-ety of reasons.[25]

4 Types

4.1 OTC and exchange-traded

In broad terms, there are two groups of derivative con-tracts, which are distinguished by the way they are tradedin the market:

• Over-the-counter (OTC) derivatives are contractsthat are traded (and privately negotiated) directlybetween two parties, without going through an ex-

change or other intermediary. Products such asswaps, forward rate agreements , exotic options –andother exotic derivatives – arealmost always traded in

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4 4 TYPES

this way. The OTC derivative market is the largestmarket for derivatives, and is largely unregulatedwith respect to disclosure of information betweenthe parties, since the OTC market is made up ofbanks and other highly sophisticated parties, such ashedge funds. Reporting of OTC amounts is difficultbecause trades can occur in private, without activitybeing visible on any exchange.

According to the Bank for International Settlements , whorst surveyed OTC derivatives in 1995,[26] reported thatthe "gross market value, which represent the cost of re-placing all open contracts at the prevailing market prices,... increased by 74% since 2004, to $11 trillion at the endof June 2007 (BIS 2007:24).”[26] Positions in the OTCderivatives market increased to $516 trillion at the end ofJune 2007, 135% higher than the level recorded in 2004.the total outstanding notional amount is US$708 trillion

(as of June 2011).[27]

Of this total notional amount, 67%are interest rate contracts , 8% are credit default swaps(CDS), 9% are foreign exchange contracts, 2% are com-modity contracts, 1% are equity contracts, and 12% areother. Because OTC derivatives are not traded on an ex-change, there is no central counter-party. Therefore, theyare subject to counterparty risk, like an ordinary contract,since each counter-party relies on the other to perform.

• Exchange-traded derivatives (ETD) are thosederivatives instruments that are traded via special-ized derivatives exchanges or other exchanges. Aderivatives exchange is a market where individualstrade standardized contracts that have been denedby the exchange.[4] A derivatives exchange acts asan intermediary to all related transactions, and takesinitial margin from both sides of the trade to act asa guarantee. The world’s largest[28] derivatives ex-changes (by number of transactions) are the KoreaExchange (which lists KOSPI Index Futures & Op-tions), Eurex (which lists a wide range of Europeanproducts such as interest rate & index products),and CME Group (made up of the 2007 merger ofthe Chicago Mercantile Exchange and the ChicagoBoard of Trade and the 2008 acquisition of the New

York Mercantile Exchange ). According to BIS, thecombined turnover in the world’s derivatives ex-changes totaled USD 344 trillion during Q4 2005.By December 2007 the Bank for International Set-tlements reported [26] that “derivatives traded on ex-changes surged 27% to a record $681 trillion.”[26]

4.2 Common derivative contract types

Some of the common variants of derivative contracts areas follows:

1. Forwards: A tailored contract between two parties,where payment takes place at a specic time in thefuture at today’s pre-determined price.

2. Futures: are contracts to buy or sell an asset on a fu-ture date at a price specied today. A futures con-tract differs from a forward contract in that the fu-tures contract is a standardized contract written by aclearing house that operates an exchange where thecontract can be bought and sold; the forward con-tract is a non-standardized contract written by theparties themselves.

3. Options are contracts that give the owner the right,but not the obligation, to buy (in the case of a calloption) or sell (in the case of a put option) an asset.The price at which the sale takes place is known asthe strike price, and is specied at the time the par-ties enter into the option. The option contract alsospecies a maturity date. In the case of a Europeanoption, the owner has the right to require the saleto take place on (but not before) the maturity date;in the case of an American option , the owner canrequire the sale to take place at any time up to thematurity date. If the owner of the contract exercisesthis right, the counter-party has the obligation tocarry out the transaction. Options are of two types:calloption and put option. The buyer ofa call optionhasa right to buy a certain quantity of the underlyingasset, at a specied price on or before a given datein the future, but he has no obligation to carry outthis right. Similarly, the buyer of a put option hasthe right to sell a certain quantity of an underlyingasset, at a specied price on or before a given datein the future, but he has no obligation to carry out

this right.

4. Binary options are contracts that provide the ownerwith an all-or-nothing prot prole.

5. Warrants : Apart from the commonly used short-dated options which have a maximum maturity pe-riod of one year, there exist certain long-dated op-tions as well, known as warrants. These are gener-ally traded over the counter.

6. Swaps are contracts to exchange cash (ows) onor before a specied future date based on the

underlying value of currencies exchange rates,bonds/interest rates, commodities exchange , stocksor other assets. Another term which is commonlyassociated with swap is swaption , a term for what isbasically an option on the forward swap. Similar tocall and put options, swaptions are of two kinds: re-ceiver and payer . In the case of a receiver swaptionthere is an option wherein one can receive xed andpay oating; in the case of a payer swaption one hasthe option to pay xed and receive oating.

Swaps can basically be categorized

into two types:• Interest rate swap: These basi-

callynecessitate swapping only

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4.4 Credit default swap 5

interest associated cash owsin the same currency, betweentwo parties.

• Currency swap: In this kindof swapping, the cash ow

between the two parties in-cludes both principal and in-terest. Also, the money whichis being swapped is in differentcurrency for both parties. [29]

Some common examples of these derivatives are the fol-lowing:

4.3 Collateralized debt obligationA collateralized debt obligation (CDO ) is a type ofstructuredasset-backed security (ABS).[30] Originally de-veloped for the corporate debt markets, over time CDOsevolved to encompass the mortgageand mortgage-backedsecurity (MBS) markets. [31] Like other private-label se-curities backed by assets, a CDO can be thought of as apromise to pay investors in a prescribed sequence, basedon the cash ow the CDO collects from the pool ofbonds or other assets it owns. The CDO is “sliced” into“tranches”, which “catch” the cash ow of interest andprincipal payments in sequence based on seniority. [32] Ifsome loans default and the cash collected by the CDO isinsufficient to pay all of its investors, those in the lowest,most “junior” tranches suffer losses rst. The last to losepayment from default are the safest, most senior tranches.Consequently, coupon payments (and interest rates) varyby tranchewith the safest/most senior tranches paying thelowest and the lowest tranches paying the highest ratesto compensate for higher default risk. As an example, aCDO might issue the following tranches in order of safe-ness: Senior AAA (sometimes known as “super senior”);Junior AAA; AA; A; BBB; Residual.[33]

Separate special purpose entities—rather than the parentinvestment bank—issue the CDOs and pay interest to in-vestors. As CDOs developed, some sponsors repackagedtranches into yet another iteration called "CDO-Squared"or the “CDOs of CDOs”.[33] In the early 2000s, CDOswere generally diversied,[34] but by 2006–2007—whenthe CDOmarket grewto hundreds of billions of dollars—this changed. CDO collateral became dominated notby loans, but by lower level (BBB or A) tranches re-cycled from other asset-backed securities, whose assetswere usually non-prime mortgages.[35] These CDOs havebeen called “the engine that powered the mortgage sup-ply chain” for nonprime mortgages, [36] and are credited

with giving lenders greater incentive to make non-primeloans[37] leading up to the 2007-9 subprime mortgage cri-sis.

4.4 Credit default swap

A credit default swap (CDS ) is a nancial swap agree-ment that the seller of the CDS will compensate the buyer(the creditor of the reference loan) in the event of a loandefault (by the debtor) or other credit event. The buyerof the CDS makes a series of payments (the CDS “fee”or “spread”) to the seller and, in exchange, receives apayoff if the loan defaults. It was invented by BlytheMasters from JP Morgan in 1994. In the event of de-fault the buyer of the CDS receives compensation (usu-ally the face value of the loan), and the seller of the CDStakes possession of the defaulted loan. [38] However, any-one can purchase a CDS, even buyers who do not holdthe loan instrument and who have no direct insurable in-terest in the loan (these are called “naked” CDSs). Ifthere are more CDS contracts outstanding than bonds inexistence, a protocol exists to hold a credit event auc-

tion; the payment received is usually substantially lessthan the face value of the loan.[39] Credit default swapshave existed since the early 1990s, and increased in useafter 2003. By the end of 2007, the outstanding CDSamount was $62.2 trillion,[40] falling to $26.3 trillion bymid-year 2010 [41] but reportedly $25.5 [42] trillion in early2012. CDSs are not traded on an exchange and thereis no required reporting of transactions to a governmentagency.[43] During the 2007-2010 nancial crisis the lackof transparency in this large market became a concernto regulators as it could pose a systemic risk.[44][45][46][47]

In March 2010, the [DTCC] Trade Information Ware-house (see Sources of Market Data) announced it wouldgive regulators greater access to its credit default swapsdatabase.[48] CDS data can be used by nancial profes-sionals, regulators, and the media to monitor how themarket views credit risk of any entity on which a CDSis available, which can be compared to that provided bycredit rating agencies. U.S. courts may soon be followingsuit.[38] Most CDSs are documented using standard formsdrafted by the International Swaps and Derivatives Asso-ciation (ISDA), although there are many variants.[44] Inaddition to the basic, single-name swaps, there are basketdefault swaps (BDSs), index CDSs, funded CDSs (alsocalled credit-linked notes), as well as loan-only credit

default swaps (LCDS). In addition to corporations andgovernments, the reference entity can include a specialpurpose vehicle issuing asset-backed securities .[49] Someclaim that derivatives such as CDS are potentially dan-gerous in that they combine priority in bankruptcy with alack of transparency. [45] A CDS can be unsecured (with-out collateral) and be at higher risk for a default.

4.5 Forwards

In nance, a forward contract or simply a forward

is a non-standardized contract between two parties tobuy or to sell an asset at a specied future time at aprice agreed upon today, making it a type of derivative

https://en.wikipedia.org/wiki/Asset-backed_securityhttps://en.wikipedia.org/wiki/Special_purpose_vehiclehttps://en.wikipedia.org/wiki/Special_purpose_vehiclehttps://en.wikipedia.org/wiki/Credit-linked_notehttps://en.wikipedia.org/wiki/Basket_(finance)https://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttps://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Associationhttps://en.wikipedia.org/wiki/Credit_rating_agencyhttps://en.wikipedia.org/wiki/Credit_riskhttps://en.wikipedia.org/wiki/Financial_risk_managementhttps://en.wikipedia.org/wiki/Financial_risk_managementhttps://en.wikipedia.org/wiki/Derivative_(finance)#Sources_of_market_datahttps://en.wikipedia.org/wiki/Systemic_riskhttps://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010https://en.wikipedia.org/wiki/Credit_default_swap#Auctionshttps://en.wikipedia.org/wiki/Credit_default_swap#Auctionshttps://en.wikipedia.org/wiki/Insurable_interesthttps://en.wikipedia.org/wiki/Insurable_interesthttps://en.wikipedia.org/wiki/Face_valuehttps://en.wikipedia.org/wiki/J.P._Morgan_&_Co.https://en.wikipedia.org/wiki/Blythe_Mastershttps://en.wikipedia.org/wiki/Blythe_Mastershttps://en.wikipedia.org/wiki/Credit_eventhttps://en.wikipedia.org/wiki/Default_(finance)https://en.wikipedia.org/wiki/Swap_(finance)https://en.wikipedia.org/wiki/Subprime_mortgage_crisishttps://en.wikipedia.org/wiki/Subprime_mortgage_crisishttps://en.wikipedia.org/wiki/Credit_ratings#Corporate_credit_ratingshttps://en.wikipedia.org/wiki/CDO-Squaredhttps://en.wikipedia.org/wiki/Investment_bankhttps://en.wikipedia.org/wiki/Special_purpose_entityhttps://en.wikipedia.org/wiki/Default_riskhttps://en.wikipedia.org/wiki/Coupon_(bond)https://en.wikipedia.org/wiki/Tranchehttps://en.wikipedia.org/wiki/Asset-backed_securityhttps://en.wikipedia.org/wiki/Structured_financehttps://en.wikipedia.org/wiki/Currency_swap

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6 4 TYPES

instrument. [4][50] This is in contrast to a spot contract,which is an agreement to buy or sell an asset on its spotdate, which may vary depending on the instrument, forexample most of the FX contracts have Spot Date twobusiness days from today. The party agreeing to buy theunderlying asset in the future assumes a long position,and the party agreeing to sell the asset in the future as-sumes a short position. The price agreed upon is calledthe delivery price, which is equal to the forward price atthe time the contract is entered into. The price of theunderlying instrument, in whatever form, is paid beforecontrol of the instrument changes. This is one of themany forms of buy/sell orders where the time and date oftrade is not the sameas the value date where the securitiesthemselves are exchanged.

The forward price of such a contract is commonly con-trasted with the spot price, which is the price at whichthe asset changes hands on the spot date. The differencebetween the spot and theforward price is the forward pre-mium or forward discount, generally considered in theform of a prot, or loss, by the purchasing party. For-wards, like other derivative securities, can be used tohedge risk (typically currency or exchange rate risk), as ameans of speculation, or to allow a party to take advan-tage of a quality of the underlying instrument which istime-sensitive.

A closely related contract is a futures contract ; they differin certain respects. Forward contracts are very similarto futures contracts, except they are not exchange-traded,or dened on standardized assets.[51] Forwards also typi-cally have no interim partial settlements or “true-ups” inmargin requirements like futures—such that the partiesdo not exchange additional property securing the partyat gain and the entire unrealized gain or loss builds upwhile the contract is open. However, being traded overthe counter (OTC), forward contracts specication canbe customizedand mayinclude mark-to-market and dailymargin calls. Hence, a forward contract arrangementmight call for the loss party to pledge collateral or addi-tional collateral to better secure the party at gain. In otherwords, the terms of the forward contract will determinethe collateral calls basedupon certain “trigger” events rel-

evant to a particular counterparty such as among otherthings, credit ratings, value of assets under managementor redemptions over a specic time frame (e.g., quarterly,annually).

4.6 Futures

In nance, a 'futures contract' (more colloquially, fu-tures ) is a standardized contract between two parties tobuy or sell a specied asset of standardized quantity andquality for a price agreed upon today (the futures price )with delivery and payment occurring at a specied fu-

ture date, the delivery date , making it a derivative prod-uct (i.e. a nancial product that is derived from an un-derlying asset). The contracts are negotiated at a futures

exchange, which acts as an intermediary between buyerand seller. The party agreeing to buy the underlying as-set in the future, the “buyer” of the contract, is said tobe "long", and the party agreeing to sell the asset in thefuture, the “seller” of the contract, is said to be "short".

While the futures contract species a trade taking placein the future, the purpose of the futures exchange is to actas intermediary and mitigate the risk of default by eitherparty in the intervening period. For this reason, the fu-tures exchange requires both parties to put up an initialamount of cash (performance bond), the margin. Mar-gins, sometimes set as a percentage of the value of thefutures contract, need to be proportionally maintained atall times during the life of the contract to underpin thismitigation because the price of the contract will vary inkeeping with supply and demand and will change dailyand thus one party or the other will theoretically be mak-ing or losing money. To mitigate risk and the possibil-ity of default by either party, the product is marked tomarket on a daily basis whereby the difference betweenthe prior agreed-upon price and the actual daily futuresprice is settled on a daily basis. This is sometimes knownas the variation margin where the futures exchange willdraw money out of the losing party’s margin account andput it into the other party’s thus ensuring that the correctdaily loss or prot is reected in the respective account.If the margin account goes below a certain value set bythe Exchange, then a margin call is made and the accountowner must replenish the margin account. This process isknown as “markingto market”. Thus on the delivery date,

the amount exchanged is not the specied price on thecontract but the spot value (i.e., the original value agreedupon, since any gain or loss has already been previouslysettled by marking to market). Upon marketing the strikeprice is often reached and creates lots of income for the“caller”.

A closely related contract is a forward contract . A for-ward is like a futures in that it species the exchangeof goods for a specied price at a specied future date.However, a forward is not tradedon an exchange and thusdoes not have the interim partial payments due to mark-ing to market. Nor is the contract standardized, as on

the exchange. Unlike an option, both parties of a futurescontract must fulll thecontract on the delivery date. Theseller delivers the underlying asset to the buyer, or, if itis a cash-settled futures contract, then cash is transferredfrom the futures trader who sustained a loss to the onewho made a prot. To exit the commitment prior to thesettlement date, the holder of a futures position can closeout its contract obligations by taking the opposite positionon another futures contract on the same asset and settle-ment date. The difference in futures prices is then a protor loss.

https://en.wikipedia.org/wiki/Position_(finance)https://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Forward_contracthttps://en.wikipedia.org/wiki/Spot_pricehttps://en.wikipedia.org/wiki/Futures_contract#Marginhttps://en.wikipedia.org/wiki/Short_(finance)https://en.wikipedia.org/wiki/Long_(finance)https://en.wikipedia.org/wiki/Futures_exchangehttps://en.wikipedia.org/wiki/Futures_exchangehttps://en.wikipedia.org/wiki/Contracthttps://en.wikipedia.org/wiki/Financehttps://en.wikipedia.org/wiki/Over-the-counter_(finance)https://en.wikipedia.org/wiki/Over-the-counter_(finance)https://en.wikipedia.org/wiki/Futures_contract#Futures_versus_forwardshttps://en.wikipedia.org/wiki/Futures_contract#Futures_versus_forwardshttps://en.wikipedia.org/wiki/Futures_contracthttps://en.wikipedia.org/wiki/Speculationhttps://en.wikipedia.org/wiki/Hedge_(finance)https://en.wikipedia.org/wiki/Profit_(accounting)https://en.wikipedia.org/wiki/Forward_premiumhttps://en.wikipedia.org/wiki/Forward_premiumhttps://en.wikipedia.org/wiki/Spot_datehttps://en.wikipedia.org/wiki/Spot_pricehttps://en.wikipedia.org/wiki/Forward_pricehttps://en.wikipedia.org/wiki/Security_(finance)https://en.wikipedia.org/wiki/Value_datehttps://en.wikipedia.org/wiki/Forward_pricehttps://en.wikipedia.org/wiki/Delivery_pricehttps://en.wikipedia.org/wiki/Short_positionhttps://en.wikipedia.org/wiki/Long_positionhttps://en.wikipedia.org/wiki/Spot_contract

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4.9 Swaps 7

4.7 Mortgage-backed securities

A mortgage-backed security (MBS ) is a asset-backedsecurity that is secured by a mortgage, or more com-monly a collection (“pool”) of sometimes hundreds ofmortgages. The mortgages are sold to a group of indi-viduals (a government agency or investment bank) that"securitizes", or packages, the loans together into a se-curity that can be sold to investors. The mortgages ofan MBS may be residential or commercial, depending onwhether it is an Agency MBS or a Non-Agency MBS;in the United States they may be issued by structuresset up by government-sponsored enterprises like FannieMae or Freddie Mac, or they can be “private-label”, is-sued by structures set up by investment banks. The struc-ture of the MBS may be known as “pass-through”, wherethe interest and principal payments from the borrower orhomebuyer pass through it to the MBS holder, or it may

be more complex, made up of a pool of other MBSs.Other types of MBSinclude collateralized mortgage obli-gations (CMOs, often structured as real estate mortgageinvestment conduits) and collateralized debt obligations(CDOs).[52]

The shares of subprime MBSs issued by various struc-tures, suchas CMOs, are not identical but rather issuedastranches (French for “slices”), each with a different levelof priority in the debt repayment stream, giving them dif-ferent levels of risk and reward. Tranches—especiallythe lower-priority, higher-interest tranches—of an MBSare/were often further repackaged and resold as collater-

ized debt obligations.[53]

These subprime MBSs issuedby investment banks were a major issue in the subprimemortgage crisis of 2006–2008 . The total face value ofan MBSdecreases over time, because like mortgages, andunlike bonds, and most other xed-income securities, theprincipal in an MBS is not paid back as a single paymentto the bond holder atmaturity but rather is paid along withthe interest in each periodic payment (monthly, quarterly,etc.). This decrease in face value is measured by theMBS’s “factor”, the percentage of the original “face” thatremains to be repaid.

4.8 Options

In nance, an option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy orsell an underlying asset or instrument at a specied strikeprice on or before a specied date. The seller has thecorresponding obligation to fulll the transaction—thatis to sell or buy—if the buyer (owner) “exercises” theoption. The buyer pays a premium to the seller for thisright. An option that conveys to the owner the right tobuy something at a certain price is a "call option"; an op-tion that conveys the right of the owner to sell something

at a certain price is a "put option". Both are commonlytraded, but for clarity, the call option is more frequentlydiscussed. Options valuation is a topic of ongoing re-

search in academic and practical nance. In basic terms,the value of an option is commonly decomposed into twoparts:

• The rst part is the “intrinsic value”, dened asthe difference between the market value of theunderlying and the strike price of the given option.

• The second part is the “time value”, which dependson a set of other factors which, through a mul-tivariable, non-linear interrelationship, reect thediscounted expected value of that difference at ex-piration.

Although options valuation has been studied since the19th century, the contemporary approach is based onthe Black–Scholes model, which was rst published in1973.[54][55]

Options contracts have been known for many centuries.However, both trading activity and academic interest in-creased when, as from 1973, options were issued withstandardized terms and traded through a guaranteedclearing house at the Chicago Board Options Exchange.Today, many options are created in a standardized formand traded through clearing houses on regulated optionsexchanges, while other over-the-counter options are writ-ten as bilateral, customized contracts between a singlebuyer and seller, one or both of which may be a dealer ormarket-maker. Options are part of a larger class of nan-cial instruments known as derivative products or simply

derivatives.[4][56]

4.9 Swaps

A swap is a derivative in which two counterpartiesexchange cash ows of one party’s nancial instrumentfor those of the other party’s nancial instrument. Thebenets in question depend on the type of nancial in-struments involved. For example, in the case of a swapinvolving two bonds, the benets in question can be theperiodic interest (coupon) payments associated with suchbonds. Specically, two counterparties agree to ex-

change one stream of cash ows against another stream.These streams are called the swap’s “legs”. The swapagreement denes the dates when the cash ows are to bepaid and the way they are accrued and calculated. Usuallyat the time when the contract is initiated, at least one ofthese series of cash ows is determined by an uncertainvariable such as a oating interest rate, foreign exchangerate, equity price, or commodity price. [4]

The cash ows are calculated over a notional principalamount. Contrary to a future, a forward or an option,the notional amount is usually not exchanged betweencounterparties. Consequently, swaps can be in cash or

collateral. Swaps can be used to hedge certain risks suchas interest rate risk, or to speculate on changes in the ex-pected direction of underlying prices.

https://en.wikipedia.org/wiki/Speculationhttps://en.wikipedia.org/wiki/Interest_rate_riskhttps://en.wikipedia.org/wiki/Hedge_(finance)https://en.wikipedia.org/wiki/Collateral_(finance)https://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Forward_contracthttps://en.wikipedia.org/wiki/Futures_contracthttps://en.wikipedia.org/wiki/Notional_principal_amounthttps://en.wikipedia.org/wiki/Notional_principal_amounthttps://en.wikipedia.org/wiki/Foreign_exchange_ratehttps://en.wikipedia.org/wiki/Foreign_exchange_ratehttps://en.wikipedia.org/wiki/Floating_interest_ratehttps://en.wikipedia.org/wiki/Accrualhttps://en.wikipedia.org/wiki/Cash_flowhttps://en.wikipedia.org/wiki/Coupon_(bond)https://en.wikipedia.org/wiki/Bond_(finance)https://en.wikipedia.org/wiki/Financial_instrumenthttps://en.wikipedia.org/wiki/Tradehttps://en.wikipedia.org/wiki/Counterpartyhttps://en.wikipedia.org/wiki/Derivative_productshttps://en.wikipedia.org/wiki/Over-the-counter_(finance)https://en.wikipedia.org/wiki/Exchange_(organized_market)https://en.wikipedia.org/wiki/Exchange_(organized_market)https://en.wikipedia.org/wiki/Chicago_Board_Options_Exchangehttps://en.wikipedia.org/wiki/Black%E2%80%93Scholes_modelhttps://en.wikipedia.org/wiki/Expected_valuehttps://en.wikipedia.org/wiki/Discountedhttps://en.wikipedia.org/wiki/Underlyinghttps://en.wikipedia.org/wiki/Put_optionhttps://en.wikipedia.org/wiki/Call_optionhttps://en.wikipedia.org/wiki/Expiration_(options)https://en.wikipedia.org/wiki/Strike_pricehttps://en.wikipedia.org/wiki/Strike_pricehttps://en.wikipedia.org/wiki/Financial_instrumenthttps://en.wikipedia.org/wiki/Assethttps://en.wikipedia.org/wiki/Underlyinghttps://en.wikipedia.org/wiki/Financehttps://en.wikipedia.org/wiki/Debthttps://en.wikipedia.org/wiki/Bond_(finance)https://en.wikipedia.org/wiki/Subprime_mortgage_crisishttps://en.wikipedia.org/wiki/Subprime_mortgage_crisishttps://en.wikipedia.org/wiki/Tranchehttps://en.wikipedia.org/wiki/Collateralized_debt_obligationhttps://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttps://en.wikipedia.org/wiki/Collateralized_mortgage_obligationhttps://en.wikipedia.org/wiki/Freddie_Machttps://en.wikipedia.org/wiki/Fannie_Maehttps://en.wikipedia.org/wiki/Fannie_Maehttps://en.wikipedia.org/wiki/Government-sponsored_enterprisehttps://en.wikipedia.org/wiki/Commercial_mortgage-backed_securityhttps://en.wikipedia.org/wiki/Residential_mortgage-backed_securityhttps://en.wikipedia.org/wiki/Securitizationhttps://en.wikipedia.org/wiki/Mortgage_loanhttps://en.wikipedia.org/wiki/Mortgagehttps://en.wikipedia.org/wiki/Asset-backed_securityhttps://en.wikipedia.org/wiki/Asset-backed_security

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8 6 VALUATION

Swaps were rst introduced to the public in 1981when IBM and the World Bank entered into a swapagreement. [57] Today, swaps are among the most heav-ily traded nancial contracts in the world: the totalamount of interest rates and currency swaps outstand-ing is more thаn $348 trillion in 2010, according to theBank for International Settlements (BIS).The ve generictypes of swaps, in order of their quantitative importance,are: interest rate swaps, currency swaps, credit swaps,commodity swaps and equity swaps (there aremany othertypes).

5 Economic function of the deriva-tive market

Some of the salient economic functions of the derivative

market include:

1. Prices in a structured derivative market not onlyreplicate the discernment of the market partici-pants about the future but also lead the prices ofunderlying to the professed future level. On theexpiration of the derivative contract, the prices ofderivatives congregate with the prices of the under-lying. Therefore, derivatives are essential tools todetermine both current and future prices.

2. The derivatives market reallocatesriskfromthepeo-

ple who prefer risk aversion to the people who havean appetite for risk.

3. The intrinsic nature of derivatives market associatesthem to the underlying spot market. Due to deriva-tives there is a considerable increase in trade vol-umes of the underlying spot market. The dominantfactor behind such an escalation is increased partici-pation byadditional playerswho would not haveoth-erwise participated due to absence of any procedureto transfer risk.

4. As supervision, reconnaissance of the activities ofvarious participants becomes tremendously difficultin assorted markets; the establishment of an orga-nized form of market becomes all the more imper-ative. Therefore, in the presence of an organizedderivatives market, speculation can be controlled,resulting in a more meticulous environment.

5. Third parties can use publicly available derivativeprices as educated predictions of uncertain futureoutcomes, for example, the likelihood that a corpo-ration will default on its debts.[58]

In a nutshell, there is a substantial increase in savings andinvestment in the long run due to augmented activities byderivative market participant .[59]

6 Valuation

Total world derivatives from 1998 to 2007 [60] compared to total world wealth in the year 2000 [61]

6.1 Market and arbitrage-free prices

Two common measures of value are:

• Marketprice, i.e. the price at which traders arewill-ing to buy or sell the contract

• Arbitrage-free price, meaning thatno risk-free prof-its can be made by trading in these contracts (seerational pricing )

6.2 Determining the market price

For exchange-traded derivatives, market price is usuallytransparent (often published in real time by the exchange,based on all the current bids and offers placed on thatparticular contract at any one time). Complications canarise with OTC or oor-traded contracts though, as trad-ing is handled manually, making it difficult to automati-cally broadcast prices. In particular with OTC contracts,there is no central exchange to collate and disseminateprices.

6.3 Determining the arbitrage-free priceSee List of nance topics# Derivatives pricing .

The arbitrage-free price for a derivatives contract can becomplex, and there are many different variables to con-sider. Arbitrage-free pricing is a central topic of nancialmathematics . For futures/forwards the arbitrage freeprice is relatively straightforward, involving the price ofthe underlying together with the cost of carry (incomereceived less interest costs), although there can be com-plexities.

However, for options and morecomplex derivatives, pric-ing involves developing a complex pricing model: under-standing the stochastic process of the price of the under-

https://en.wikipedia.org/wiki/Stochastic_processhttps://en.wikipedia.org/wiki/Financial_mathematicshttps://en.wikipedia.org/wiki/Financial_mathematicshttps://en.wikipedia.org/wiki/List_of_finance_topics#Derivatives_pricinghttps://en.wikipedia.org/wiki/Rational_pricinghttps://en.wikipedia.org/wiki/Arbitragehttps://en.wikipedia.org/wiki/Market_pricehttps://en.wikipedia.org/wiki/Market_participanthttps://en.wikipedia.org/wiki/Speculationhttps://en.wikipedia.org/wiki/Spot_markethttps://en.wikipedia.org/wiki/Risk_aversionhttps://en.wikipedia.org/wiki/Derivative_contracthttps://en.wikipedia.org/wiki/Underlyinghttps://en.wikipedia.org/wiki/Derivative_markethttps://en.wikipedia.org/wiki/Equity_swaphttps://en.wikipedia.org/wiki/Commodity_swaphttps://en.wikipedia.org/wiki/Currency_swaphttps://en.wikipedia.org/wiki/Interest_rate_swaphttps://en.wikipedia.org/wiki/Bank_for_International_Settlementshttps://en.wikipedia.org/wiki/World_Bankhttps://en.wikipedia.org/wiki/IBM

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7.3 Counter party risk 9

lying asset is often crucial. A key equation for the theo-retical valuation of options is the Black–Scholes formula,which is based on the assumption that the cash ows froma Europeanstock option canbe replicatedbya continuousbuying and selling strategy using only the stock. A sim-plied version of this valuation technique is the binomialoptions model.OTC represents the biggest challenge in using models toprice derivatives. Since these contracts are not publiclytraded, no market price is available to validate the theo-retical valuation. Most of the model’s results are input-dependent (meaning the nal price depends heavily onhow we derive the pricing inputs).[62] Therefore, it iscommon that OTC derivatives are priced by IndependentAgents that both counterparties involved in the deal des-ignate upfront (when signing the contract).

7 Criticisms

Derivatives are often subject to the following criticisms:

7.1 Hidden tail risk

According to Raghuram Rajan , a former chief economistof the International Monetary Fund (IMF), "... it maywell be that the managers of these rms [investmentfunds] have gured out the correlations between the var-

ious instruments they hold and believe they are hedged.Yet as Chan and others (2005) point out, the lessons ofsummer 1998 following the default on Russian govern-ment debt is that correlations that are zero or negative innormal times can turn overnight to one — a phenomenonthey term “phase lock-in.” A hedged position canbecomeunhedged at the worst times, inicting substantial losseson those who mistakenly believe they are protected.”[63]

7.2 Risks

See also: List of trading losses

The use of derivatives can result in large losses becauseof the use of leverage, or borrowing. Derivatives allowinvestors to earn large returns from small movements inthe underlying asset’s price. However, investors couldlose large amounts if the price of the underlying movesagainst them signicantly. There have been several in-stances of massive losses in derivative markets, such asthe following:

• American International Group (AIG) lost

more than US$18 billion through a sub-sidiary over the preceding three quarterson credit default swaps (CDSs).[64] The

United States Federal Reserve Bank an-nounced the creation of a secured creditfacility of up to US$85 billion, to preventthe company’s collapse by enabling AIGto meet its obligations to deliver addi-tional collateral to its credit default swaptrading partners. [65]

• The loss of US$7.2 Billion by SociétéGénérale in January 2008 through mis-use of futures contracts.

• The loss of US$6.4 billion in the failedfund Amaranth Advisors , which was longnatural gas in September 2006 when theprice plummeted.

• The loss of US$4.6 billion in the failedfund Long-Term Capital Management in1998.

• The loss of US$1.3 billion equivalentin oil derivatives in 1993 and 1994 byMetallgesellschaft AG.[66]

• The loss of US$1.2 billion equivalentin equity derivatives in 1995 by BaringsBank.[67]

• UBS AG, Switzerland’s biggest bank,suffered a $2 billion loss through unau-thorized trading discovered in September2011. [68]

This comes to a staggering $39.5 billion, the majority inthe last decade after the Commodity Futures Moderniza-tion Act of 2000 was passed.

7.3 Counter party risk

Some derivatives (especially swaps) expose investors tocounterparty risk , or risk arising from the other party in anancial transaction. Different types of derivatives havedifferent levels of counter party risk. For example, stan-dardized stock options by law require the party at riskto have a certain amount deposited with the exchange,showing that they can pay for any losses; banks that helpbusinesses swap variable for xed rates on loans may docredit checks on both parties. However, in private agree-ments between two companies, for example, there maynot be benchmarks for performing due diligence and riskanalysis.

7.4 Large notional value

Derivatives typically have a large notional value . Assuch, there is the danger that their use could result in

losses for which the investor would be unable to com-pensate. The possibility that this could lead to a chainreaction ensuing in an economic crisis was pointed out

https://en.wikipedia.org/wiki/Credit_risk#Counterparty_riskhttps://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000https://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000https://en.wikipedia.org/wiki/Barings_Bankhttps://en.wikipedia.org/wiki/Barings_Bankhttps://en.wikipedia.org/wiki/Metallgesellschaft_AGhttps://en.wikipedia.org/wiki/Long-Term_Capital_Managementhttps://en.wikipedia.org/wiki/Amaranth_Advisorshttps://en.wikipedia.org/wiki/Soci%C3%A9t%C3%A9_G%C3%A9n%C3%A9ralehttps://en.wikipedia.org/wiki/Soci%C3%A9t%C3%A9_G%C3%A9n%C3%A9ralehttps://en.wikipedia.org/wiki/2008_Soci%C3%A9t%C3%A9_G%C3%A9n%C3%A9rale_trading_losshttps://en.wikipedia.org/wiki/Federal_Reserve_Systemhttps://en.wikipedia.org/wiki/Credit_default_swaphttps://en.wikipedia.org/wiki/American_International_Grouphttps://en.wikipedia.org/wiki/Investorhttps://en.wikipedia.org/wiki/Leverage_(finance)https://en.wikipedia.org/wiki/List_of_trading_losseshttps://en.wikipedia.org/wiki/International_Monetary_Fundhttps://en.wikipedia.org/wiki/Raghuram_Rajanhttps://en.wikipedia.org/wiki/Binomial_options_modelhttps://en.wikipedia.org/wiki/Binomial_options_modelhttps://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Black%E2%80%93Scholes_formulahttps://en.wikipedia.org/wiki/Valuation_of_options

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10 8 FINANCIAL REFORM AND GOVERNMENT REGULATION

by famed investor Warren Buffett in Berkshire Hath-away's 2002 annual report. Buffett called them 'nancialweapons of mass destruction.' A potential problem withderivatives is that they comprise an increasingly larger no-tional amount of assets which may lead to distortions inthe underlying capital and equities markets themselves.Investors begin to look at the derivatives markets to makea decision to buy or sell securities and so what was origi-nally meant to be a market to transfer risk now becomesa leading indicator.(See Berkshire Hathaway Annual Re-port for 2002)

8 Financial Reform and Govern-ment Regulation

Under US law and the laws of most other developedcountries, derivatives have special legal exemptions thatmake them a particularly attractive legal form to ex-tend credit. [69] The strong creditor protections affordedto derivatives counterparties, in combination with theircomplexity and lack of transparency however, can causecapital markets to underprice credit risk. This can con-tribute to credit booms, and increase systemic risks. [69]

Indeed, the use of derivatives to conceal credit risk fromthird parties while protecting derivative counterpartiescontributed to the nancial crisis of 2008 in the UnitedStates.[69][70]

In the context of a 2010 examination of the ICE Trust, anindustry self-regulatory body, Gary Gensler, the chair-man of the Commodity Futures Trading Commissionwhich regulates most derivatives, was quoted saying thatthe derivatives marketplace as it functions now “adds upto higher costs to all Americans.” More oversight of thebanks in this market is needed, he also said. Addition-ally, the report said, "[t]he Department of Justice is look-ing into derivatives, too. The department’s antitrust unitis actively investigating 'the possibility of anticompetitivepractices in the credit derivatives clearing, trading and in-formation services industries,' according to a departmentspokeswoman.”[71]

For legislators and committees responsible for nancialreform related to derivatives in theUnited States andelse-where, distinguishing between hedging and speculativederivatives activities has been a nontrivial challenge. Thedistinction is critical because regulation should help toisolate and curtail speculation with derivatives, especiallyfor “systemically signicant” institutions whose defaultcould be large enough to threaten the entire nancial sys-tem. At the same time, the legislation should allow forresponsible parties to hedge risk without unduly tying upworking capital as collateral that rms may better em-ploy elsewhere in their operations and investment. [72] In

this regard, it is importantto distinguishbetweennancial(e.g. banks) and non-nancial end-users of derivatives(e.g. real estate development companies) because these

rms’ derivatives usage is inherently different. More im-portantly, the reasonable collateral that secures these dif-ferent counterparties can be very different. The distinc-tion between these rms is not always straight forward(e.g. hedge funds or even some private equity rms donotneatly t either category). Finally, even nancial usersmust be differentiated, as 'large' banks may classiedas “systemically signicant” whose derivatives activitiesmust be more tightly monitored and restricted than thoseof smaller, local and regional banks.

Over-the-counter dealing will be less common as theDodd–Frank Wall Street Reform and Consumer Protec-tion Act comes into effect. The law mandated the clear-ing of certain swaps at registered exchanges and imposedvarious restrictions on derivatives. To implement Dodd-Frank, the CFTC developednew rules in at least30 areas .The Commission determines which swaps are subject tomandatory clearing and whether a derivatives exchange iseligible to clear a certain type of swap contract.Nonetheless, the above and other challenges of the rule-making process have delayed full enactment of aspects ofthe legislation relating to derivatives. The challenges arefurther complicated by the necessity to orchestrate glob-alized nancial reform among the nations that comprisethe world’s major nancial markets, a primary responsi-bility of the Financial Stability Board whose progress isongoing.[73]

In the U.S., by February 2012 the combined effort of theSEC and CFTC had produced over 70 proposed and nalderivatives rules.[74] However, both of them had delayedadoption of a number of derivatives regulations becauseof the burden of other rulemaking, litigation and oppo-sition to the rules, and many core denitions (such asthe terms “swap,” “security-based swap,” “swap dealer,”“security-based swap dealer,” “major swap participant”and “major security-based swap participant”) had still notbeen adopted. [74] SEC Chairman Mary Schapiro opined:“At the end of the day, it probably does not make senseto harmonize everything [between the SEC and CFTCrules] because some of these products are quite differentand certainly the market structures are quite different.” [75]

On February 11, 2015, the Securities and ExchangeCommission (SEC) released two nal rules toward estab-lishing a reporting and public disclosure framework forsecurity-based swap transaction data.[76] The two rulesare not completely harmonized with the requirementswith CFTC requirements.

In November 2012, the SEC and regulators from Aus-tralia, Brazil, the European Union, Hong Kong, Japan,Ontario, Quebec, Singapore, and Switzerland met to dis-cuss reforming the OTC derivatives market, as had beenagreed by leaders at the 2009 G-20 Pittsburgh summitin September 2009. [77] In December 2012, they releaseda joint statement to the effect that they recognized thatthe market is a global one and “rmly support the adop-tion and enforcement of robust and consistent standards

https://en.wikipedia.org/wiki/2009_G-20_Pittsburgh_summithttps://en.wikipedia.org/wiki/Mary_Schapirohttps://en.wikipedia.org/wiki/Financial_Stability_Boardhttp://www.cftc.gov/LawRegulation/DoddFrankAct/index.htmhttps://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Acthttps://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Acthttps://en.wikipedia.org/wiki/United_States_Department_of_Justicehttps://en.wikipedia.org/wiki/Commodity_Futures_Trading_Commissionhttps://en.wikipedia.org/wiki/Gary_Genslerhttps://en.wikipedia.org/wiki/Intercontinental_Exchangehttp://www.berkshirehathaway.com/2002ar/2002ar.pdfhttp://www.berkshirehathaway.com/2002ar/2002ar.pdfhttps://en.wikipedia.org/wiki/Berkshire_Hathawayhttps://en.wikipedia.org/wiki/Berkshire_Hathawayhttps://en.wikipedia.org/wiki/Warren_Buffett

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Country leaders at the 2009 G-20 Pittsburgh summit

in and across jurisdictions”, with the goals of mitigatingrisk, improving transparency, protecting against marketabuse, preventing regulatory gaps, reducing the potentialfor arbitrage opportunities, and fostering a level playingeld for market participants. [77] They also agreed on theneed to reduce regulatory uncertainty and provide marketparticipants with sufficient clarity on laws and regulationsby avoiding, to the extentpossible, the application of con-icting rules to the same entities and transactions, andminimizing the application of inconsistent and duplica-tive rules.[77] At the same time, they noted that “completeharmonization – perfect alignment of rules across juris-dictions” would be difficult, because of jurisdictions’ dif-ferences in law, policy, markets, implementation timing,and legislative and regulatory processes.[77]

On December 20, 2013 the CFTC provided informationon its swaps regulation “comparability” determinations.The release addressed the CFTC’s cross-border compli-ance exceptions. Specically it addressed which entitylevel and in some cases transaction-level requirements insix jurisdictions (Australia, Canada, the European Union,Hong Kong, Japan, and Switzerland) it found comparableto its own rules, thus permitting non-US swap dealers,major swap participants, and the foreign branches of USSwap Dealers and major swap participants in these juris-dictions to comply with local rules in lieu of Commissionrules.[78]

8.1 Reporting

Mandatory reporting regulations are being nalized ina number of countries, such as Dodd Frank Act inthe US, the European Market Infrastructure Regulations(EMIR) in Europe, as well as regulations in Hong Kong,Japan, Singapore, Canada, and other countries.[79] TheOTC Derivatives Regulators Forum (ODRF), a groupof over 40 world-wide regulators, provided trade repos-itories with a set of guidelines regarding data access to

regulators, and the Financial Stability Board and CPSSIOSCO also made recommendations in with regard toreporting. [79]

DTCC, through its “Global Trade Repository” (GTR)service, manages global trade repositories for interestrates, and commodities, foreign exchange, credit, andequity derivatives.[79] It makes global trade reports tothe CFTC in the U.S., and plans to do the same forESMA in Europe andfor regulators in Hong Kong, Japan,and Singapore.[79] It covers cleared and uncleared OTCderivatives products, whether or not a trade is electroni-cally processed or bespoke. [79][80][81]

9 Glossary

• Bilateral netting: A legally enforceable arrangementbetween a bank and a counter-party that creates asingle legal obligation covering all included individ-ual contracts. This means that a bank’s obligation,in the event of the default or insolvency of one of theparties, would be the net sum of allpositive and neg-ative fair values of contracts included in the bilateralnetting arrangement.

• Counterparty: The legal and nancial term for theother party in a nancial transaction.

• Credit derivative: A contract that transfers creditrisk from a protection buyer to a credit protectionseller. Credit derivative products can take manyforms, such as credit default swaps, credit linkednotes and total return swaps.

• Derivative: A nancial contract whose value is de-rived from the performance of assets, interest rates,currency exchange rates, or indexes. Derivativetransactions include a wide assortment of nancialcontracts including structured debt obligations anddeposits, swaps, futures, options, caps, oors, col-lars, forwards and various combinations thereof.

• Exchange-traded derivative contracts : Standard-ized derivative contracts (e.g., futures contracts andoptions) that are transacted on an organized futuresexchange.

• [Gross negative fair value: The sum of the fair val-ues of contracts where the bank owes money toits counter-parties, without taking into account net-ting. This represents the maximumlosses the bank’scounter-parties would incur if the bank defaults andthere is no netting of contracts, and no bank collat-eral was held by the counter-parties.

• Gross positive fair value: The sum total of the fairvalues of contracts where the bank is owed moneyby its counter-parties, without taking into accountnetting. This represents the maximum losses a bank

could incur if all its counter-parties default and thereis no netting of contracts, and the bank holds nocounter-party collateral.

https://en.wikipedia.org/wiki/Futures_exchangehttps://en.wikipedia.org/wiki/Futures_exchangehttps://en.wikipedia.org/wiki/Option_(finance)https://en.wikipedia.org/wiki/Futures_contracthttps://en.wikipedia.org/wiki/Exchange-traded_derivative_contracthttps://en.wikipedia.org/wiki/Credit_default_swaphttps://en.wikipedia.org/wiki/Credit_riskhttps://en.wikipedia.org/wiki/Credit_riskhttps://en.wikipedia.org/wiki/Credit_derivativehttps://en.wikipedia.org/wiki/Counterpartyhttps://en.wikipedia.org/wiki/Bilateral_nettinghttps://en.wikipedia.org/wiki/Depository_Trust_&_Clearing_Corporationhttps://en.wikipedia.org/wiki/IOSCOhttps://en.wikipedia.org/wiki/European_Market_Infrastructure_Regulationhttps://en.wikipedia.org/wiki/Dodd_Frank_Acthttps://en.wikipedia.org/wiki/Level_playing_fieldhttps://en.wikipedia.org/wiki/Level_playing_fieldhttps://en.wikipedia.org/wiki/Arbitragehttps://en.wikipedia.org/wiki/Market_abusehttps://en.wikipedia.org/wiki/Market_abusehttps://en.wikipedia.org/wiki/Transparency_(market)https://en.wikipedia.org/wiki/2009_G-20_Pittsburgh_summit

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12 10 FINANCIAL DERIVATIVE TRADING COMPANIES

• High-risk mortgage securities: Securities where theprice or expected average life is highly sensitive tointerest rate changes, as determined by the U.S.Federal Financial Institutions Examination Councilpolicy statement on high-risk mortgage securities.

• Notional amount: The nominal or face amount thatis used to calculate payments made on swaps andother risk management products. This amount gen-erally does not change hands and is thus referred toas notional.

• Over-the-counter (OTC) derivative contracts: Pri-vately negotiated derivative contracts that are trans-acted off organized futures exchanges.

• Structured notes: Non-mortgage-backed debt secu-rities, whose cash ow characteristics depend on oneor more indices and / or have embedded forwards or

options.• Total risk-based capital: The sum of tier 1 plus tier

2 capital. Tier 1 capital consists of common share-holders equity, perpetual preferred shareholders eq-uity with noncumulative dividends, retained earn-ings, and minority interests in the equity accountsof consolidated subsidiaries. Tier 2 capital consistsof subordinated debt, intermediate-term preferredstock, cumulative and long-term preferred stock,and a portion ofa bank’s allowancefor loan and leaselosses.

10 Financial derivative tradingcompanies

• Alpari Group

• Anyoption

• AvaTrade

• Banc De Binary

• Cantor Fitzgerald

• CitiFX Pro

• City Index Group

• CMC Markets

• CommexFX

• Cu

• Darwinex

• DBFX

• eToro

• ETX Capital

• Finspreads

• First Prudential Markets

• FXCM

• FXdirekt Bank

• FXOpen

• FxPro

• Gain Capital

• Hirose Financial

• I-Access Investors

• IDealing

• IFC Markets

• IG Group

• InstaForex• Interactive Brokers Group

• Integral Forex

• InterTrader

• IQ Option

• IronFX

• Marex Spectron

• MF Global

• MFX Broker

• MRC Markets

• Oanda Corporation

• OptionsXpress

• Pepperstone

• Plus500

• Saxo Bank

• Spreadex

• Sucden

• TeleTrade

• TFI Markets

• Thinkorswim

• Varengold Bank

• Wizetrade

• Worldspreads

• XM.com

• X-Trade Brokers

• ZuluTrade

https://en.wikipedia.org/wiki/ZuluTradehttps://en.wikipedia.org/wiki/X-Trade_Brokershttps://en.wikipedia.org/wiki/XM.comhttps://en.wikipedia.org/wiki/Worldspreadshttps://en.wikipedia.org/wiki/Wizetradehttps://en.wikipedia.org/wiki/Varengold_Bankhttps://en.wikipedia.org/wiki/Thinkorswimhttps://en.wikipedia.org/wiki/TFI_Marketshttps://en.wikipedia.org/wiki/TeleTradehttps://en.wikipedia.org/wiki/Sucdenhttps://en.wikipedia.org/wiki/Spreadexhttps://en.wikipedia.org/wiki/Saxo_Bankhttps://en.wikipedia.org/wiki/Plus500https://en.wikipedia.org/wiki/Pepperstonehttps://en.wikipedia.org/wiki/OptionsXpresshttps://en.wikipedia.org/wiki/Oanda_Corporationhttps://en.wikipedia.org/wiki/MRC_Marketshttps://en.wikipedia.org/wiki/MFX_Brokerhttps://en.wikipedia.org/wiki/MF_Globalhttps://en.wikipedia.org/wiki/Marex_Spectronhttps://en.wikipedia.org/wiki/IronFXhttps://en.wikipedia.org/wiki/IQ_Optionhttps://en.wikipedia.org/wiki/InterTraderhttps://en.wikipedia.org/wiki/Integral_Forexhttps://en.wikipedia.org/wiki/Interactive_Brokers_Grouphttps://www.instaforex.com/https://en.wikipedia.org/wiki/IG_Grouphttp://www.ifcmarkets.com/https://en.wikipedia.org/wiki/IDealinghttps://en.wikipedia.org/wiki/I-Access_Investorshttps://en.wikipedia.org/wiki/Hirose_Financialhttps://en.wikipedia.org/wiki/Gain_Capitalhttps://en.wikipedia.org/wiki/FxProhttps://en.wikipedia.org/wiki/FXOpenhttps://en.wikipedia.org/wiki/FXdirekt_Bankhttps://en.wikipedia.org/wiki/FXCMhttps://en.wikipedia.org/wiki/First_Prudential_Marketshttps://en.wikipedia.org/wiki/Finspreadshttps://en.wikipedia.org/wiki/ETX_Capitalhttps://en.wikipedia.org/wiki/ETorohttps://en.wikipedia.org/wiki/DBFXhttps://en.wikipedia.org/wiki/Darwinexhttp://www.commexfx.com/https://en.wikipedia.org/wiki/CMC_Marketshttps://en.wikipedia.org/wiki/City_Index_Grouphttps://en.wikipedia.org/wiki/CitiFX_Prohttps://en.wikipedia.org/wiki/Cantor_Fitzgeraldhttps://en.wikipedia.org/wiki/Banc_De_Binaryhttps://en.wikipedia.org/wiki/AvaTradehttps://en.wikipedia.org/wiki/Anyoptionhttps://en.wikipedia.org/wiki/Alpari_Grouphttps://en.wikipedia.org/wiki/Allowance_for_Loan_and_Lease_Losses_(ALLL)https://en.wikipedia.org/wiki/Allowance_for_Loan_and_Lease_Losses_(ALLL)https://en.wikipedia.org/wiki/Preferred_stockhttps://en.wikipedia.org/wiki/Preferred_stockhttps://en.wikipedia.org/wiki/Subordinated_debthttps://en.wikipedia.org/wiki/Minority_interesthttps://en.wikipedia.org/wiki/Retained_earningshttps://en.wikipedia.org/wiki/Retained_earningshttps://en.wikipedia.org/wiki/Tier_2_capitalhttps://en.wikipedia.org/wiki/Tier_2_capitalhttps://en.wikipedia.org/wiki/Tier_1_capitalhttps://en.wikipedia.org/wiki/Debt_securitieshttps://en.wikipedia.org/wiki/Debt_securitieshttps://en.wikipedia.org/wiki/Structured_notehttps://en.wikipedia.org/wiki/Over-the-counter_(finance)https://en.wikipedia.org/wiki/Face_amounthttps://en.wikipedia.org/wiki/Notional_amounthttps://en.wikipedia.org/wiki/Federal_Financial_Institutions_Examination_Council

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13

11 See also

• Credit derivative

• Equity derivative

•

Exotic derivative• Financial engineering

• Foreign exchange derivative

• Freight derivative

• Ination derivative

• Interest rate derivative

• Property derivatives

• Weather derivative

12 References

[1] Derivatives (Report). Office of the Comptroller of theCurrency, U.S. Department of Treasury. RetrievedFebruary 2013. A derivative is a nancial contract whosevalue is derived from the performance of some underlyingmarket factors, such as interest rates, currency exchangerates, and commodity, credit, or equity prices. Derivativetransactions include an assortment of nancial contracts,including structured debt obligations and deposits, swaps,futures, options, caps, oors, collars, forwards, and vari-ous combinations thereof.

[2] “Derivative Denition”, Investopedia

[3] Koehler, Christian. “The Relationship between the Com-plexity of Financial Derivatives and Systemic Risk”.Working Paper : 10–11.

[4] John C. Hull, Options, Futures and Other Derivatives (6thedition), Prentice Hall: New Jersey, 2006.

[5] Mark Rubinstein (1999). Rubinstein on Derivatives . RiskBooks. ISBN 1-899332-53-7.

[6] Koehler, Christian. “The Relationship between the Com-plexity of Financial Derivatives and Systemic Risk”.Working Paper : 10.

[7] Kaori Suzuki and David Turner (December 10, 2005).“Sensitive politics over Japan’s staple crop delays rice fu-tures plan”. The Financial Times . Retrieved October 23,2010.

[8] “Clear and Present Danger; Centrally cleared deriva-tives.(clearing houses)". The Economist (EconomistNewspaper Ltd.(subscription required)). April 12, 2012.Retrieved May 10, 2013.

[9] Liu, Qiao; Lejot, Paul (2013). “Debt, Derivatives andComplex Interactions”. Finance in Asia: Institutions, Reg-ulation and Policy . Douglas W. Arne. New York: Rout-ledge. p. 343. ISBN 978-0-415-42319-9 .

[10] The Budget and Economic Outlook: Fiscal Years 2013 to2023 (PDF). Congressional Budget Office. February 5,2013. Retrieved March 15, 2013.

[11] “Swapping bad ideas: A big battle is unfolding over aneven bigger market”. The Economist . April 27, 2013. Re-trieved May 10, 2013.

[12] “World GDP: In search of growth”. The Economist (Economist Newspaper Ltd.). May 25, 2011. RetrievedMay 10, 2013.

[13] Sheridan, Barrett (April 2008). “600,000,000,000,000?" .Newsweek Inc. Retrieved May 12, 2013. – via HighBeam(subscription required)

[14] Khullar, Sanjeev (2009). “Using Derivatives to Create Al-pha”. In John M. Longo. Hedge Fund Alpha: A Frame-work for Generating and Understanding Investment Per- formance . Singapore: World Scientic . p. 105. ISBN978-981-283-465-2 . Retrieved September 14, 2011.

[15] LemkeandLins, Soft Dollars and OtherTrading Activities ,§§2:47 - 2:54 (Thomson West, 2013-2014 ed.).

[16] Don M. Chance; Robert Brooks (2010). “AdvancedDerivatives and Strategies”. Introduction to Derivatives and Risk Management (8th ed.). Mason, OH: CengageLearning. pp. 483–515. ISBN 978-0-324-60120-6 . Re-trieved September 14, 2011.

[17] Shirreff, David (2004). “Derivatives and leverage”.Dealing With Financial Risk . The Economist. p. 23.ISBN 1-57660-162-5 . Retrieved September 14, 2011.

[18] Peterson, Sam (2010). The Atlantic. “There’sa Derivative in Your Cereal” http://www.theatlantic.com/business/archive/2010/07/theres-a-derivative-in-your-cereal/60582/

[19] Chisolm, Derivatives Demystied (Wiley 2004)

[20] Chisolm, Derivatives Demystied (Wiley 2004) Notionalsum means there is no actual principal.

[21] News.BBC.co.uk, “How Leeson broke the bank – BBCEconomy”

[22] Chernenko, Sergey and Faulkender, Michael. The TwoSides of Derivatives Usage: Hedging and Speculatingwith Interest Rate Swaps http://www.rhsmith.umd.edu/faculty/faulkender/swaps_JFQA_final.pdf

[23] Knowledge@Wharton (2012). “The Changing Useof Derivatives: More Hedging, Less Speculation”http://knowledge.wharton.upenn.edu/article.cfm?articleid=709

[24] Guay, Wayne R. andKothari, S.P. (2001). “HowMuch doFirms Hedge with Derivatives?" http://papers.ssrn.com/sol3/papers.cfm?abstract_id=253036

[25] Knowledge@Wharton (2006). “The Role of Deriva-tives in Corporate Finances: Are Firms Betting theRanch?" http://knowledge.wharton.upenn.edu/article.cfm?articleid=1346

http://knowledge.wharton.upenn.edu/article.cfm?articleid=1346http://knowledge.wharton.upenn.edu/article.cfm?articleid=1346http://papers.ssrn.com/sol3/papers.cfm?abstract_id=253036http://papers.ssrn.com/sol3/papers.cfm?abstract_id=253036http://knowledge.wharton.upenn.edu/article.cfm?articleid=709http://knowledge.wharton.upenn.edu/article.cfm?articleid=709http://www.rhsmith.umd.edu/faculty/faulkender/swaps_JFQA_final.pdfhttp://www.rhsmith.umd.edu/faculty/faulkender/swaps_JFQA_final.pdfhttp://news.bbc.co.uk/2/hi/business/375259.stmhttp://www.theatlantic.com/business/archive/2010/07/theres-a-derivative-in-your-cereal/60582/http://www.theatlantic.com/business/archive/2010/07/theres-a-derivative-in-your-cereal/60582/http://www.theatlantic.com/business/archive/2010/07/theres-a-derivative-in-your-cereal/60582/https://en.wikipedia.org/wiki/Special:BookSources/1-57660-162-5https://en.wikipedia.org/wiki/International_Standard_Book_Numberhttps://books.google.com/books?id=mwirEO_f1DkChttps://en.wikipedia.org/wiki/Special:BookSources/978-0-324-60120-6https://en.wikipedia.org/wiki/International_Standard_Book_Numberhttps://en.wikipedia.org/wiki/Cengage_Learninghttps://en.wikipedia.org/wiki/Cengage_Learninghttps://en.wikipedia.org/wiki/Mason,_OHhttps://books.google.com/books?id=DT0nnLDMYTgChttps://books.google.com/books?id=DT0nnLDMYTgChttps://en.wikipedia.org/wiki/Special:BookSources/978-981-283-465-2https://en.wikipedia.org/wiki/International_Standard_Book_Numberhttps://en.wikipedia.org/wiki/World_Scientifichttps://en.wikipedia.org/wiki/Singaporehttps://books.google.com/books?id=uv73DVVSgAsChttps://books.google.com/books?id=uv73DVVSgAsChttps://books.google.com/books?id=uv73DVVSgAsChttp://www.highbeam.com/doc/1G1-187503475.htmlhttp://www.economist.com/blogs/dailychart/2011/05/world_gdphttp://www.economist.com/news/finance-and-economics/21576681-big-battle-unfolding-over-even-bigger-market-swapping-bad-ideashttp://www.economist.com/news/finance-and-economics/21576681-big-battle-unfolding-over-even-bigger-market-swapping-bad-ideashttps://en.wikipedia.org/wiki/Congressional_Budget_Officehttp://www.cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdfhttp://www.cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdfhttps://en.wikipedia.org/wiki/Special:BookSources/978-0-415-42319-9https://en.wikipedia.org/wiki/International_Standard_Book_Numberhttps://books.google.com/?id=NOBLXqkicKMC&pg=PA337&dq=true+size+derivative+market#v=onepage&q=true%2520size%2520derivative%2520market&f=falsehttps://books.google.com/?id=NOBLXqkicKMC&pg=PA337&dq=true+size+derivative+market#v=onepage&q=true%2520size%2520derivative%2520market&f=falsehttp://www.economist.com/node/21552217http://www.economist.com/node/21552217https://en.wikipedia.org/wiki/The_Financial_Timeshttp://www.ft.com/cms/s/0/d9f45d80-6922-11da-bd30-0000779e2340.htmlhttp://www.ft.com/cms/s/0/d9f45d80-6922-11da-bd30-0000779e2340.htmlhttp://ssrn.com/abstract=2511541http://ssrn.com/abstract=2511541https://en.wikipedia.org/wiki/Special:BookSources/1-899332-53-7https://en.wikipedia.org/wiki/International_Standard_Book_Numberhttps://en.wikipedia.org/wiki/Mark_Rubinsteinhttp://ssrn.com/abstract=2511541http://ssrn.com/abstract=2511541https://en.wikipedia.org/wiki/Investopediahttp://www.investopedia.com/terms/d/derivative.asphttps://en.wikipedia.org/wiki/U.S._Department_of_Treasuryhttps://en.wikipedia.org/wiki/Office_of_the_Comptroller_of_the_Currencyhttps://en.wikipedia.org/wiki/Office_of_the_Comptroller_of_the_Currencyhttp://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/index-derivatives.htmlhttps://en.wikipedia.org/wiki/Weather_derivativehttps://en.wikipedia.org/wiki/Property_derivativeshttps://en.wikipedia.org/wiki/Interest_rate_derivativehttps://en.wikipedia.org/wiki/Inflation_derivativehttps://en.wikipedia.org/wiki/Freight_derivativehttps://en.wikipedia.org/wiki/Foreign_exchange_derivativehttps://en.wikipedia.org/wiki/Financial_engineeringhttps://en.wikipedia.org/wiki/Exotic_derivativehttps://en.wikipedia.org/wiki/Equity_derivativehttps://en.wikipedia.org/wiki/Credit_derivative

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14 12 REFERENCES

[26] Ryan Stever; Christian Upper; Goetz von Peter (Decem-ber 2007). BIS Quarterly Review (PDF) (Report). Bankfor International Settlements.

[27] BIS survey: The Bank for International Settlements (BIS)semi-annual OTC [derivatives market report, for end

of June 2008, showed US$683.7 trillion total notionalamounts outstanding of OTCderivatives with a gross mar-ket value of US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics .

[28] Futures and Options Week : According to gures publishedin F&O Week October 10, 2005. See also FOW Website .

[29] “Financial Markets: A Beginner’s Module”.

[30] An “asset-backed security” is used as an umbrella termfora type of security backed by a pool of assets—includingcollateralized debt obligations and mortgage-backed se-curities (Example: “The capital market in which asset-

backed securities are issued and traded is composed ofthree main categories: ABS, MBS and CDOs”. (source:Vink, Dennis. “ABS, MBS and CDO compared: An em-pirical analysis” (PDF). August 2007 . Munich PersonalRePEc Archive. Retrieved July 13, 2013.)—and sometimes for a particular type of that security—one backed by consumer loans (example: “As a ruleof thumb, securitization issues backed by mortgages arecalled MBS, and securitization issues backed by debt obli-gations are called CDO, [and]Securitization issues backedby consumer-backed products—car loans, consumer loansand credit cards, among others—are called ABS. sourceVink, Dennis. “ABS, MBS and CDO compared: An em-pirical analysis” (PDF). August 2007 . Munich PersonalRePEc Archive. Retrieved July 13, 2013.,see also “What are Asset-Backed Securities?". SIFMA.Retrieved July 13, 2013. Asset-backed securities, calledABS, are bonds or notes backed by nancial assets. Typi-cally these assets consist of receivables other than mort-gage loans, such as credit card receivables, auto loans,manufactured-housing contracts and home-equity loans.)

[31] Lemke, Lins and Picard, Mortgage-Backed Securities ,§5:15 (Thomson West, 2014).

[32] Koehler, Christian. “The Relationship between the Com-plexity of Financial Derivatives and Systemic Risk”.

Working Paper : 17.

[33] Lemke, Lins and Smith, Regulation of Investment Compa-nies (Matthew Bender, 2014 ed.).

[34] Bethany McLean and Joe Nocera, All the Devils Are Here,the Hidden History of the Financial Crisis , Portfolio, Pen-guin, 2010, p.120

[35] “Final Report of the National Commission on the Causesof the Financial