Derivative (finance)
The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange.
[9][10] The assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation.
From the economic point of view, financial derivatives are cash flows that are conditioned stochastically and discounted to present value.
The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately.
Option products (such as interest rate swaps) provide the buyer the right, but not the obligation to enter the contract under the terms specified.
Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet").
It was this type of derivative that investment magnate Warren Buffett referred to in his famous 2002 speech in which he warned against "financial weapons of mass destruction".
[20] Derivatives are used for the following: Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract.
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 regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.
Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchanges According to the Bank for International Settlements, who first surveyed OTC derivatives in 1995,[34] reported that the "gross market value, which represent the cost of replacing all open contracts at the prevailing market prices, ... increased by 74% since 2004, to $11 trillion at the end of June 2007 (BIS 2007:24).
To maintain these products' net asset value, these funds' administrators must employ more sophisticated financial engineering methods than what's usually required for maintenance of traditional ETFs.
The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.
[42] If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first.
CDO collateral became dominated not by loans, but by lower level (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages.
[53] [54][55] In March 2010, the [DTCC] Trade Information Warehouse announced it would give regulators greater access to its credit default swaps database.
However, being traded over the counter (OTC), forward contracts specification can be customized and may include mark-to-market and daily margin calls.
[clarification needed] In other words, the terms of the forward contract will determine the collateral calls based upon certain "trigger" events relevant to a particular counterparty such as among other things, credit ratings, value of assets under management or redemptions over a specific time frame (e.g., quarterly, annually).
For this reason, the futures exchange requires both parties to put up an initial amount of cash (performance bond), the margin.
Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices.
[69] Therefore, it is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal designate upfront (when signing the contract).
Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one – a phenomenon they term "phase lock-in".
The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report.
A potential problem with derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in the underlying capital and equities markets themselves.
The strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency however, can cause capital markets to underprice credit risk.
At the same time, the legislation should allow for responsible parties to hedge risk without unduly tying up working capital as collateral that firms may better employ elsewhere in their operations and investment.
"[81] On February 11, 2015, the Securities and Exchange Commission (SEC) released two final rules toward establishing a reporting and public disclosure framework for security-based swap transaction data.
In November 2012, the SEC and regulators from Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been agreed by leaders at the 2009 G-20 Pittsburgh summit in September 2009.
[85] It makes global trade reports to the CFTC in the U.S., and plans to do the same for ESMA in Europe and for regulators in Hong Kong, Japan, and Singapore.
