Derivatives are financial instruments whose value changes in response to the changes in underlying variables. Financial instruments are cash evidence of an ownership interest in an entity or a contractual right to receive or deliver cash or another financial instrument The main types of derivatives are futures, forwards, options, and swaps. In Finance, a futures contract is a standardized Contract, traded on a Futures exchange, to buy or sell a certain Underlying instrument A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future Options are financial instruments that convey the right but not the obligation to engage in a future transaction on some Underlying security, or in a Futures For the Thoroughbred horse racing champion see Swaps (horse. In finance a swap is a derivative in which two counterparties
The main use of derivatives is to reduce risk for one party. Risk is a Concept that denotes the precise probability of specific eventualities The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. A contract is an exchange of promises between two or more parties to do or refrain from doing an act which is enforceable in a court of law Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). A commodity is anything for which there is demand but which is supplied without qualitative differentiation across a market Software for Fixed assets management and Stock control developed in 2004. Stocks are devices used since Medieval times for Public humiliation, Corporal punishment, and Torture. In Finance, a bond is a Debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and Interest Interest is a fee paid on borrowed capital Assets lent include Money, Shares, Consumer goods through Hire purchase, major assets In Finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how A stock market index is a method of measuring a section of the Stock market. CPI redirects here For other uses see CPI (disambiguation. A consumer price index ( CPI) is a measure of the average price of consumer In Finance, inflation derivatives (or inflation-indexed derivatives refer to over-the-counter and exchange-traded derivatives that are used to transfer Their performance can determine both the amount and the timing of the pay-offs.
Contents |
Uses
Insurance and Hedging
One use of derivatives is to be used as a tool to transfer risk by taking the opposite position in the underlying asset. The field of finance refers to the concepts of Time, Money and Risk and how they are interrelated In Economics, a financial market is a mechanism that allows people to easily buy and sell ( Trade) financial Securities (such as stocks and bonds The bond market (also known as the debt, credit, or fixed income market) is a Financial market where participants buy and sell Debt A stock market, or (equity market is a private or public market for the trading of company Stock and derivatives of company The foreign exchange ( currency or forex or FX) market refers to the market for currencies. The derivatives markets are the Financial markets for derivatives The market can be divided into two that for exchange traded derivatives and that for Commodity markets are markets where raw or primary products are exchanged In Finance, the money market is the global Financial market for short-term borrowing and lending The spot market or cash market is a Commodities or Securities market in which goods are sold for Cash and delivered immediately Over-the-counter ( OTC) trading is to Trade Financial instruments such as Stocks bonds, commodities or derivatives Real estate is a legal term (in some jurisdictions notably in the USA, United Kingdom There are two basic financial market participant categories Investor vs See Investor AB for the Swedish investment company An investor is any party that makes an Investment. Speculation, in a financial context is making an investment that increases the overall risk in a portfolio Institutional investors are organizations which pool large sums of money and invest those sums in companies Corporate finance is an area of Finance dealing with the financial decisions Corporations make and the tools and analysis used to make these decisions Structured finance is a broad term used to describe a sector of Finance that was created to help transfer Risk using complex legal and corporate entities Capital budgeting (or investment appraisal is the planning process used to determine whether a firm's long term Investments such as new machinery replacement machinery new Financial risk management is the practice of creating economic value in a firm by using Financial instruments to manage exposure to Risk, particularly Accountancy or accounting is the measurement statement or provision of assurance about financial information primarily used by Lenders managers, Financial statements (or financial reports) are formal records of a business' financial The most general definition of an audit is an evaluation of a person organization system process project or product A credit rating agency ( CRA) is a company that assigns Credit ratings for Issuers of certain types of Debt obligations as well as the debt instruments Personal finance is the application of the principles of Finance to the monetary decisions of an individual or family unit Credit is the provision of resources (such as granting a Loan) by one party to another party where that second party does not reimburse the first party immediately thereby generating Debt is that which is owed usually referencing Assets owed but the term can cover other obligations A contract of employment is a category of Contract used in Labour law to attribute right and responsibilities between parties to a bargain Retirement is the point where a person stops employment completely A financial planner or personal financial planner is a practicing professional who helps people deal with various personal financial issues through proper planning which includes Public finance is a field of economics concerned with paying for collective or governmental activities and with the administration and design of those activities A banker or bank is a Financial institution whose primary activity is to act as a payment agent for customers and to borrow and lend money Fractional-reserve banking is the banking practice in which Banks keep only a fraction of the value of their Bank notes and demand deposits in reserve A central bank, reserve bank, or monetary authority is the entity responsible for the Monetary policy of a country or of a group of member states This is a list of Banks throughout the world Africa Central Bank Bank A deposit account is a current account at a Banking institution that allows money to be deposited and withdrawn by the account holder with the transactions and resulting balance A loan is a type of Debt. This article focuses exclusively on monetary loans although in practice any material object might be lent In Economics, money supply, or money stock, is the total amount of money available in an Economy at a particular point in time Financial regulations are a form of Regulation or supervision which subjects Financial institutions to certain requirements restrictions and guidelines aiming to There are a variety of Finance designations or Accreditations that can be earned and awarded to those in the finance industry Accounting scandals, or corporate accounting scandals are political and business scandals which arise with the disclosure of misdeeds by trusted executives A stock market bubble is a type of Economic bubble taking place in Stock markets when price of Stocks rise and become overvalued by any measure of Stock A recession is a contraction phase of the Business cycle. The U A stock market crash is a sudden dramatic decline of Stock prices across a significant cross-section of a Stock market. Risk is a Concept that denotes the precise probability of specific eventualities For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. In Finance, a futures contract is a standardized Contract, traded on a Futures exchange, to buy or sell a certain Underlying instrument Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.
Also, stock index futures and options are known as derivative products because they derive their existence from actual market indexes, but have no intrinsic characteristics of their own. In addition to that, one of the reason some believe they lead to greater market volatility is that a huge amounts of securities can be controlled by relatively small amounts of margin or option premiums.
Speculation and arbitrage
Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. In Economics and Finance, arbitrage is the practice of taking advantage of a price differential between two or more Markets striking a combination of matching
In addition to directional plays (i. e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. Volatility most frequently refers to the Standard deviation of the continuously compounded returns of a Financial instrument with a specific time horizon This technique is commonly used when speculating with traded options. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Nicholas Leeson (born February 25, 1967) is a former derivatives trader whose unsupervised speculative trading caused the collapse of Barings Barings Bank (1762 to 1995 was the oldest Merchant bank in London until its collapse in 1995 after one of the bank's employees Nick Leeson, lost £827 Through a combination of poor judgement on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1. The Great Hanshin Earthquake, or Kobe earthquake as it is more commonly known outside of Japan, was an Earthquake in Japan that occurred on Tuesday 3 billion loss that bankrupted the centuries-old financial institution.
Types of derivatives
OTC and exchange-traded
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished 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. Over-the-counter ( OTC) trading is to Trade Financial instruments such as Stocks bonds, commodities or derivatives Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. For the Thoroughbred horse racing champion see Swaps (horse. In finance a swap is a derivative in which two counterparties In finance a forward rate agreement ( FRA) is a Forward contract in which one party pays a fixed interest rate and receives a floating interest rate equal to a In Finance, an exotic option is a derivative which has features making it more complex than commonly traded products ( Vanilla options. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 516 trillion (as of June 2007)[1]. The Bank for International Settlements (or BIS) is an International organization of Central banks which "fosters international monetary and
- Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A futures exchange is a central financial exchange where people can trade standardized Futures contracts; that is a contract to buy specific quantities of a Commodity 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. In finance a margin is collateral that the holder of a position in securities, options, or Futures contracts has to deposit to cover The world's largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade). Korea Exchange (KRX was created through the integration of the three existing Korean spot & futures exchanges ( Korea Stock Exchange, Korea Futures Exchange and KOSDAQ The Korea Composite Stock Price Index or KOSPI (코스피지수 is the index of all Common stocks traded on the Stock Market Division—previously Korea Eurex is a major futures and options exchange for European Benchmark Derivatives featuring open and low-cost electronic access globally CME Group Inc ( is the world’s largest Futures exchange. CME Group was created July 12 2007 from the merger between the Chicago Mercantile Exchange (CME and the Chicago The Chicago Board of Trade ( CBOT) established in 1848 is the world's oldest futures and options exchange. According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs(tm) and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.
Common Derivative contract types
There are three major classes of derivatives:
- Futures/Forwards, which are contracts to buy or sell an asset at a specified future date. In Finance, a futures contract is a standardized Contract, traded on a Futures exchange, to buy or sell a certain Underlying instrument A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future
- Optionals, which are contracts that give a holder the right to buy or sell an asset at a specified future date.
- Swappings, where the two parties agree to exchange cash flows.
Examples
Some common examples of these derivatives are:
| UNDERLYING | CONTRACT TYPE | ||||
|---|---|---|---|---|---|
| Exchange-traded futures | Exchange-traded options | OTC swap | OTC forward | OTC option | |
| Equity Index | DJIA Index future NASDAQ Index future |
Option on DJIA Index future Option on NASDAQ Index future |
Equity swap | Back-to-back | n/a |
| Money market | Eurodollar future Euribor future |
Option on Eurodollar future Option on Euribor future |
Interest rate swap | Forward rate agreement | Interest rate cap and floor Swaption Basis swap |
| Bonds | Bond future | Option on Bond future | n/a | Repurchase agreement | Bond option |
| Single Stocks | Single-stock future | Single-share option | Equity swap | Repurchase agreement | Stock option Warrant Turbo warrant |
| Credit | n/a | n/a | Credit default swap | n/a | Credit default option |
Other examples of underlying exchangeables are:
- Economic derivatives that pay off according to economic reports ([1]) as measured and reported by national statistical agencies
- Energy derivatives that pay off according to a wide variety of indexed energy prices. A stock market index is a method of measuring a section of the Stock market. The Dow Jones Industrial Average ( also called the DJIA, Dow 30, INDP, or informally the Dow Jones or The Dow) is one of several The NASDAQ (acronym of National Association of Securities Dealers Automated Quotations) is an American Stock exchange. The Dow Jones Industrial Average ( also called the DJIA, Dow 30, INDP, or informally the Dow Jones or The Dow) is one of several The NASDAQ (acronym of National Association of Securities Dealers Automated Quotations) is an American Stock exchange. An equity swap is a swap where a set of future cash flows are exchanged between two counterparties In Finance, the money market is the global Financial market for short-term borrowing and lending An interest rate swap is a derivative in which one party exchanges a stream of Interest payments for another party's stream of cash flows In finance a forward rate agreement ( FRA) is a Forward contract in which one party pays a fixed interest rate and receives a floating interest rate equal to a Interest rate cap An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. A basis swap is an Interest rate swap which involves the exchange of two floating rate Financial instruments A floating-floating interest rate swap under which the In Finance, a bond is a Debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and Interest Better known as Repurchase agreements ( RPs or repos) a Sale and Repurchase Agreement has a Borrower (seller/cash receiver sell securities In Finance, a bond option is an OTC-traded financial instrument that facilitates an option to buy or sell a particular bond at a certain date for a particular price Software for Fixed assets management and Stock control developed in 2004. Single-stock futures (SSF's are Futures contracts with the underlying asset being one particular stock usually in batches of 100 An equity swap is a swap where a set of future cash flows are exchanged between two counterparties Options are financial instruments that convey the right but not the obligation to engage in a future transaction on some Underlying security, or in a Futures In Finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price which is usually higher than the stock Turbo warrant is a kind of Stock option. Specifically it is a Barrier option of the knock-out type A credit default swap ( CDS) is a swap contract in which a buyer makes a series of payments to a seller and in exchange receives the right to a payoff if a credit In Finance, a default option, credit default swaption or credit default option is an option to buy protection (payer option or sell protection Also known as Energy trade, Oil trade, Gas trade, Power trade. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc. )
- Commodities
- Freight derivatives
- Inflation derivatives
- Insurance derivatives
- Weather derivatives
- Credit derivatives
- Property derivatives
Portfolio
It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. A commodity is anything for which there is demand but which is supplied without qualitative differentiation across a market Freight derivative s which includes Forward Freight Agreement (FFA and options based on these are Financial instruments for trading in future levels of Freight rates In Finance, inflation derivatives (or inflation-indexed derivatives refer to over-the-counter and exchange-traded derivatives that are used to transfer Weather derivatives are Financial instruments that can be used by organizations or individuals as part of a Risk management strategy to reduce risk associated with In Finance, a credit derivative is a derivative whose value derives from the Credit risk on an underlying bond loan or other financial asset General Definition A property derivative is a financial derivative whose value is derived from the value of an underlying Real estate asset They simply derive their values from assets such as bonds, equities, currencies, etc. and are used to either hedge those assets or improve the returns on those assets.
Cash flow
The payments between the parties may be determined by:
- the price of some other, independently traded asset in the future (e. g. , a common stock);
- the level of an independently determined index (e. A voting share (also called common stock or ordinary share) is a share of Stock giving the Stockholder the right to vote on matters g. , a stock market index or heating-degree-days);
- the occurrence of some well-specified event (e. g. , a company defaulting);
- an interest rate;
- an exchange rate;
- or some other factor. In Finance, default occurs when a debtor has not met its legal obligations according to the debt contract e Interest is a fee paid on borrowed capital Assets lent include Money, Shares, Consumer goods through Hire purchase, major assets In Finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how
Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.
Valuation
Market and arbitrage-free prices
Two common measures of value are:
- Market price, i. Market price is an economic concept with commonplace familiarity it is the price that a good or service is offered at or will fetch in the marketplace it is of interest mainly in the e. the price at which traders are willing to buy or sell the contract
- Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing
Determining the market price
For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). In Economics and Finance, arbitrage is the practice of taking advantage of a price differential between two or more Markets striking a combination of matching Rational pricing is the assumption in Financial economics that asset prices (and hence asset pricing models will reflect the Arbitrage-free price of the asset as Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.
Determining the arbitrage-free price
The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. Mathematical finance is the branch of Applied mathematics concerned with the Financial markets. The stochastic process of the price of the underlying asset is often crucial. A stochastic process, or sometimes random process, is the counterpart to a deterministic process (or Deterministic system) in Probability theory. A key equation for the theoretical valuation of options is the Black–Scholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. Because the values of option contracts depend on a number of different variables in addition to the value of the underlying asset they are complex to value The term Black–Scholes refers to three closely related concepts The Black–Scholes model is a mathematical model of the market for an equity in which the equity's Options are financial instruments that convey the right but not the obligation to engage in a future transaction on some Underlying security, or in a Futures A simplified version of this valuation technique is the binomial options model. BOPM redirects here for other uses see BOPM (disambiguation. In Finance, the binomial options pricing model (BOPM provides a generalisable
Controversy
Derivatives are often subject to the following criticisms:
- The use of derivatives can result in large losses due to the use of leverage. 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 moves against them significantly. There have been several instances of massive losses in derivative markets, including:
-
- The Nick Leeson affair in 1994. Nicholas Leeson (born February 25, 1967) is a former derivatives trader whose unsupervised speculative trading caused the collapse of Barings
- The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U. Orange County is a county in Southern California, United States. S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1. 6 billion through derivatives trading. Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded. Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example: [3]
-
- The bankruptcy of Long-Term Capital Management in 2000. Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay their Creditors Creditors may file a bankruptcy petition against Long-Term Capital Management ( LTCM) was a US Hedge fund which failed spectacularly in the late 1990s leading to a massive bailout by other major banks
- The loss of $6. 4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted. Amaranth Advisors LLC was an American multistrategy Hedge fund managing US$9 billion in assets
- The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts. The January 2008 Société Générale trading loss incident was an incident in which the bank Société Générale lost approximately € 4 Société Générale ( is one of the main European financial services companies and also maintains extensive activities in others parts of the world
- Derivatives (especially swaps) expose investors to counter-party risk. For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate. This chain reaction effect worries certain economists, who posit that since many derivative contracts are so new, the effect could lead to a large disaster. Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis. This has been a cause for concern among many economists.
- Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it. Insurance, in Law and Economics, is a form of Risk management primarily used to hedge against the Risk of a contingent loss
- Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by legendary investor Warren Buffett in Berkshire Hathaway's annual report. Warren Buffett (born August 30 1930 is an American Investor, Businessman, and Philanthropist. Buffet stated that he regarded them as 'financial weapons of mass destruction'. A weapon of mass destruction ( WMD) is a weapon which can kill large numbers of humans and/or cause great damage to man-made structures (e The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. Many economists are worried that derivatives may cause an economic crisis at some point in the future.
- Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U. Marriner Stoddard Eccles ( September 9, 1890 &ndash December 18, 1977) was a U S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression. The Chairman of the Board of Governors of the Federal Reserve System is the head of the central banking system of the United States and one of the most
Nevertheless, the use of derivatives has its benefits:
- Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system. An economic system is a System that involves the production, distribution and consumption of goods and services between Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility. In Game theory and Economic theory, zero-sum describes a situation in which a participant's gain or loss is exactly balanced by the losses or gains of the other In Economics, utility is a measure of the relative satisfaction from or desirability of Consumption of various Goods and services.
- Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century. Alan Greenspan (born March 6 1926 in New York City) is an American Economist and was from 1987 to 2006 the Chairman of the Federal Reserve of A recession is a contraction phase of the Business cycle. The U
Definitions
- Bilateral Netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal obligation covering all included individual contracts. Bilateral netting is a legally enforceable arrangement between a Bank and a counterparty that creates a single legal obligation covering all included individual Contracts This means that a bank’s obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.
- Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. In Finance, a credit derivative is a derivative whose value derives from the Credit risk on an underlying bond loan or other financial asset Credit risk is the risk of loss due to a debtor's non-payment of a Loan or other line of credit (either the principal or Interest (coupon or both Faced Credit derivative products can take many forms, such as credit default options, credit limited notes and total return swaps.
- Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.
- Exchange-traded derivative contracts: Standardized derivative contracts (e. g. futures contracts and options) that are transacted on an organized futures exchange. In Finance, a futures contract is a standardized Contract, traded on a Futures exchange, to buy or sell a certain Underlying instrument Options are financial instruments that convey the right but not the obligation to engage in a future transaction on some Underlying security, or in a Futures A futures exchange is a central financial exchange where people can trade standardized Futures contracts; that is a contract to buy specific quantities of a Commodity
- Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the bank’s counter-parties would incur if the bank defaults and there is no netting of 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, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of 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, as determined by the FFIEC policy statement on high-risk mortgage securities. The Federal Financial Institutions Examination Council, or FFIEC, is a formal interagency body of the United States government empowered to prescribe uniform principles
- Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made Face value is the value of a Coin, stamp or Paper money, as printed on the coin stamp or bill itself by the minting authority This amount generally does not change hands and is thus referred to as notional.
- Over-the-counter (OTC) derivative contracts : Privately negotiated derivative contracts that are transacted off organized futures exchanges. Over-the-counter ( OTC) trading is to Trade Financial instruments such as Stocks bonds, commodities or derivatives
- Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or 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 is the core measure of a Bank 's financial strength from a Regulator 's point of view Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of Financial capital, from a Regulator 's point of view Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. In Accounting, retained earnings refers to the portion of Net income which is retained by the corporation rather than distributed to its owners as Dividends Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a bank’s allowance for loan and lease losses. In Finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt Preferred stock, also called preferred shares or preference shares, is typically a higher ranking stock than Voting shares, and its terms are negotiated
Footnotes
- ^ BIS survey: The Bank for International Settlements (BIS), in their semi-annual OTC derivatives market activity report from November 2007 that, at the end of June 2007, the total notional amounts outstanding of OTC derivatives was $516 trillion with a gross market value of $11 trillion. The Bank for International Settlements (or BIS) is an International organization of Central banks which "fosters international monetary and The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made See also OTC derivatives markets activity in the second half of 2004. )
- ^ Futures and Options Week: According to figures published in F&O Week 10 October 2005. Events 680 - Battle of Karbala: Shia Imam Husayn bin Ali, the grandson of the Prophet Muhammad, is decapitated Year 2005 ( MMV) was a Common year starting on Saturday (link displays full calendar of the Gregorian calendar. See also FOW Website.
- ^ Risk Magazine article on post-Katrina financing
After the storm, Risk Magazine (2006), Navroz Patel
See also
- FX Option
- Equity option
- Interest rate derivative
External links
- BBC NEWS | Business |Buffett warns on investment 'time bomb'
- Slate Magazine | Moneybox |Stocks Are So 20th Century By Daniel Gross — A short introduction to Derivatives
- Finance Articles
- Derivatives Financial Products Report from WG&L
- PLC magazine, Derivatives Uncovered: swaps, futures and all that jazz, by Edmund Parker
- A beginner's guide to derivatives, MoneyWeek, September 29, 2006
- Derivatives Overview: What are they, Do they work, Uses, Abuses
Dapyx Software network: MP3 Explorer | Ebook Manager | Zenithic