Derivatives Are Financial Instruments Rinu

Derivatives are financial instruments, whose prices are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be the price of an asset (e.g., commodities, equities (stock), residential mortgages, commercial real estate, loans, bonds), the value of an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items. Credit derivatives are based on loans, bonds or other forms of credit. The main types of derivatives are forwards, futures, options, and swaps. Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to take a risk and make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). This activity is known as speculation. Hedging Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade. [edit] Speculation and arbitrage Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. 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 futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.[1] Types of derivatives [edit] 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. 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 largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding

notional amount is $684 trillion (as of June 2008)[2]. Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform. •

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. The world's largest[3] 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 and the 2008 acquisition of the New York Mercantile 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 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: 1. 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. 2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.

3. 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. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date. [edit] Examples Some common examples of these derivatives are: CONTRACT TYPES UNDERLYING

Equity Index

Exchangetraded futures

Exchangetraded options

OTC swap

DJIA Index future NASDAQ Index future

Option on DJIA Index future Option on NASDAQ Index future

Equity swap

Eurodollar future Money market Euribor future Bonds

Single Stocks

Credit

Bond future

Option on Eurodollar Interest future rate Option on swap Euribor future Option on Bond future

Total return swap

OTC forward

OTC option

Back-to-back n/a

Interest rate cap and Forward rate floor agreement Swaption Basis swap Repurchase agreement

Bond option

Single-stock Single-share future option

Equity swap

Repurchase agreement

Stock option Warrant Turbo warrant

n/a

Credit default swap

n/a

Credit default option

n/a

Other examples of underlying exchangeables are: • •

Property (mortgage) derivatives Economic derivatives that pay off according to economic reports [1] as measured and reported by national statistical agencies

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Energy derivatives that pay off according to a wide variety of indexed energy prices. 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[citation needed] Weather derivatives Credit derivatives

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.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.

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. [edit] Valuation

Total world derivatives from 1998-2007[4] compared to total world wealth in the year 2000[5]

[edit] Market and arbitrage-free prices Two common measures of value are: • •

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

[edit] 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). 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. [edit] 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. The stochastic process of the price of the underlying asset is often crucial. 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. A simplified version of this valuation technique is the binomial options model. Criticisms Derivatives are often subject to the following criticisms: [edit] Possible large losses See also: List of trading losses The use of derivatives can result in large losses due to the use of leverage, or borrowing. 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, such as: •

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The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the US federal government[6]. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written.[7] It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters. The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.

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The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted. The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998. The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.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.[citation needed] Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example:[8] The Nick Leeson affair in 1994

[edit] Counter-party risk 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. 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. [edit] Unsuitably high risk for small/inexperienced investors 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. Large notional value

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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 famed investor Warren Buffett in Berkshire Hathaway's annual report. Buffett called them 'financial weapons of mass destruction.' 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.

(See Berkshire Hathaway Annual Report for 2002) [edit] Leverage of an economy's debt Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, 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. (See Berkshire Hathaway Annual Report for 2002) [edit] Benefits Nevertheless, the use of derivatives also has its benefits: •

•

Derivatives facilitate the buying and selling of risk, and many people consider this to have a positive impact on the economic system. 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. 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.[citation needed]

[edit] 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. 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.

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Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps.

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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.

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Exchange-traded derivative contracts: Standardized derivative contracts (e.g. futures contracts and options) that are transacted on an organized futures exchange.

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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.

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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.

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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.

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Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional.

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Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges.

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Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and / or have embedded forwards or options.

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Total risk-based capital: The sum of tier 1 plus tier 2 capital. 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. 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.

Derivatives

Commodities whose value is derived from the price of some underlying asset like securities, commodities, bullion, currency, interest level, stock market index or anything else are known

as

“Derivatives”.

In more simpler form, derivatives are financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset. It is a generic term for a variety of financial instruments. Essentially, this means you buy a promise to convey ownership of the asset, rather than the asset itself. The legal terms of a contract are much more varied and flexible than the terms of property ownership. In fact, it’s this flexibility that appeals to investors. When a person invests in derivative, the underlying asset is usually a commodity, bond, stock, or currency. He bet that the value derived from the underlying asset will increase or decrease by a certain amount within a certain fixed period of time. ‘Futures’ and ‘options’ are two commodity traded types of derivatives. An ‘options’ contract gives the owner the right to buy or sell an asset at a set price on or before a given date. On the other hand, the owner of a ‘futures’ contract is obligated to buy or sell the asset. The other examples of derivatives are warrants and convertible bonds (similar to shares in that they are assets). But derivatives are usually contracts. Beyond this, the derivatives range is only limited by the imagination of investment banks. It is likely that any person who has funds invested, an insurance policy or a pension fund, that they are investing in, and exposed to, derivatives – wittingly or unwittingly. Shares or bonds are financial assets where one can claim on another person or corporation; they will be usually be fairly standardised and governed by the property of securities laws in an appropriate country. On the other hand, a contract is merely an agreement between two parties, where the contract details may not be standardised. Derivatives securities or derivatives products are in real terms contracts rather than solid as it fairly sounds.

Are Derivatives Disastrous? Disasters involving derivatives have captured the attention of the financial sector worldwide. Names like Barings, Proctor & Gamble, Orange County, etc. have come to symbolise the "dangers of derivatives". As derivatives grow to have an increasing importance in India's economy, what does this mean for us? A single trader brought down Barings Bank -- is State Bank similarly vulnerable? Specifically, on the equity market, where the first exchange--traded derivatives are likely to commence trading in early 1998, what new pitfalls lie in store for us? The first question that we will address is whether there is truly a rash of disasters. Ever since the first financial futures started trading in 1972, the worldwide derivatives industry has seen enormous growth rates, with trading volumes doubling every three years for the following twenty years. The outstanding derivatives positions that exist today typically run into many trillions of dollars. In this situation, in the early nineties, we have seen disasters involving a few billion dollars. This is not a large "failure rate". An analogy might perhaps be made with the airline industry: the number of plane crashes per year seen in the early nineties is enormously larger than what was seen in preceding decades. This only reflects the fact that many more planes fly today as compared with previous times. Derivatives are like aircraft in that they are very useful most of the time, and generate front--page disasters when things go wrong. Yet, a focus on plane crashes would not accurately convey the extent to which thousands of planes fly safely every day. The worldwide banking industry has run up hundreds of billions of dollars of losses on bad loans (especially in Japan and East Asia). If we measure losses per unit transacted, then the banking industry is hundreds of times more risky than the derivatives industry. An analogy may be made here about the risks of planes versus cars. Most laymen think that planes are riskier than automobiles. This impression is wrong : the risk of an accident, per unit kilometre travelled, is much smaller when flying. The difference between planes and automobiles is the difference between derivatives and banking: in the former case, losses make headlines. In this discussion, it is useful to demarcate two categories of derivative contracts: those which are traded at an exchange, and those which are privately negotiated (called "over--the--counter" or OTC derivatives). Exchange--traded derivatives are intrinsically safer in many directions: they ensure that users get a fair price on all trades, they involve almost zero risk of default through the role of the clearing corporation, and there is a high level of transparency. In contrast, OTC derivatives involve many difficulties: there is a risk of default by one or the other party, the price that is negotiated might not be a fair price, the complexity of the contracts often generates unsavoury sales practices and high fees for intermediaries, and the transactions are not publicly visible. Many of the famous international disasters have taken place with OTC derivatives. In India, on the equity market, SEBI is quite clear that the development of the derivatives industry should focus on exchange--traded derivatives. In the area of

commodities also, the developments of the last two years in India have centred around exchanges. It is in interest--rates and currencies, where OTC derivatives presently dominate in India, that these concerns about fairplay and credit risk are more serious. India's equity market has been the centre of bitter debates. One argument which is often heard runs as follows: "Derivatives are highly leveraged instruments, hence the proposal to create index futures and options should be viewed with great caution". This statement is inconsistent with a remarkable fact about exchange--traded index derivatives in India: they involve less danger than the existing spot market. Payments crises The index, being a diversified portfolio, is less volatile than individual securities. After taking volatility into account, the leverage that NSE's index futures market will offer is less than that available today on NSE's existing "cash" market, which is a one--week futures market. Hence the risk of payments problems are smaller on NSE's proposed index futures market than on the existing cash market. The reduced risk of NSE's index derivatives market is even more pronounced when compared with other stock exchanges in India, which lack intra--day exposure limits, charge smaller margins, and have much smaller deposits from brokerage firms. Market manipulation The index, with a market capitalisation of Rs.2.2 trillion, is much harder to manipulate than individual securities. Hence the dangers of market manipulation are smaller on an index derivatives market as compared with the existing cash market. Insider trading Individual companies are characterised by a sharp asymmetry of information, between company insiders and external investors/traders. In contrast, the index is about India's macroeconomy, where there is much less asymmetry of information. In this sense, there is less scope for malpractice on a market which trades the index. Fake certificates Trading involving physical certificates in India is fraught with dangers of fake/stolen share certificates. Index derivatives are cash settled, which makes them as safe as trades on the cash market which settle through the depository. On balance, derivatives are a new technology. Like all new technology, there is the promise of useful applications -- in this case, the major benefit is the fluency of transfer of risk across individuals and firms in the economy. As with all new technology, there are risks of damage. The introduction of aiplanes into India was viewed with suspicion by those who watched newspaper headlines about plane crashes. As the actual evidence about automobiles, banking or the existing equity market suggests, these fears are not appropriate in comparison with risks that we live with today. Yet, as is the case with all new technology, derivatives do pose a challenge of skills development. Individuals with expertise in trading one--week futures on the existing equity market will need to understand the role for index futures in their risk management and trading. Risk measurement, operational controls, and a "compliance culture" are more important today than ever before. Exchange and regulators will

need new skills in crafting regulations, and high standards of honest and thorough enforcement of these regulations. The growth of derivatives markets and the growth of these skills will go hand in hand. The experience of India's dollar--rupee forward market -- the largest derivative market in existence in India today -- is an example of how this might proceed. When this market first came about, it had a fairly restricted usage. Today, use of the forward market is routine and commonplace amongst hundreds of importers and exporters. These are firms with core competences such as exporting garments or importing crude oil: they are faced with currency risk and do not view trading in the rupee as being a core competence. The forward market enables them to proceed with their core competences while using the forward market to eliminate currency risk. The dollar-rupee forward market has typical daily trading volumes like $1.5 billion, which makes it one of the biggest financial markets in India today. Even though it is an OTC market, it has not known any serious disaster. This is a success story of regulation and skills development.