Derivatives
Derivatives are financial instruments whose value is based on an underlying assets, such as commodities, stocks, residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index or the consumer price index ). A stock option in an example of a derivative because it derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from one or more interest rate indices.
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.
Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros.
Derivatives are classified by the way they are traded in market:- Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is unregulated.
- Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.
- Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves.
- Options are contracts that give the owner the right, but not the obligation, to buy or sell an asset on or before a future date at a price specified today. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.
Institutional investors have increasingly used derivatives to either hedge their existing positions, or to speculate on given markets or commodities. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying asset moves against them significantly. There have been several instances of massive losses in derivative markets, recently.
These include:- The collapse of American International Group (AIG). An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written. This collapse resulted in the need to recapitalize AIG with $85 billion of debt provided by the US federal government.
- The bankruptcy of Long-Term Capital Management in 2000.
- The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history.
Derivatives contributed greatly to the 2008 economic collapse that was the result of the mortgage meltdown. By 2007, the derivatives market had grown into a massive bubble, from about $100 trillion to $516 trillion. When the market seized up in 2007, investors demanded payment on a type of derivatives called credit default swaps, but there was no money behind them.