Derivative (finance)


In finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:
  1. an item that can or must be bought or sold,
  2. a future act which must occur,
  3. a price at which the future transaction must take place, and
  4. a future date by which the act must take place.
A derivative's value depends on the performance of the underlier, which can be a commodity, a financial instrument, a price index, a currency, or an interest rate.
Derivatives can be used to insure against price movements, increase exposure to price movements for speculation, or get access to otherwise hard-to-trade assets or markets. Most derivatives are price guarantees. But some are based on an event or performance of an act rather than a price. Agriculture, natural gas, electricity and oil businesses use derivatives to mitigate risk from adverse weather. Derivatives can be used to protect lenders against the risk of borrowers defaulting on an obligation.
Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the 2008 financial crisis, there has been increased pressure to move derivatives to trade on exchanges.
Derivatives are one of the three main categories of financial instruments, the other two being equity and debt. 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. However, Aristotle did not define this arrangement as a derivative but as a monopoly. Bucket shops, outlawed in 1936 in the US, are a more recent historical example.

Basics

Derivatives are contracts between two parties that specify conditions under which payments are to be made between the parties. 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. The components of a firm's capital structure, e.g., bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm's assets, but this is unusual outside of technical contexts.
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. The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows derivative designers to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger, or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.
There are two groups of derivative contracts: the privately traded over-the-counter derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives that are traded through specialized derivatives exchanges or other exchanges.
Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative ; the type of underlying asset ; the market in which they trade ; and their pay-off profile.
Derivatives may broadly be categorized as "lock" or "option" products. Lock products obligate the contractual parties to the terms over the life of the contract. Option products 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 or for speculation. This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.
Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission and those details are not finalized nor fully implemented as of late 2012.

Size of market

To give an idea of the size of the derivative market, The Economist has reported that as of June 2011, the over-the-counter derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion. For the fourth quarter 2017 the European Securities Market Authority estimated the size of European derivatives market at a size of €660 trillion with 74 million outstanding contracts.
However, these are "notional" values, and some economists say that these aggregated values greatly exaggerate the market value and the true credit risk faced by the parties involved. For example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion, the value of the market was estimated to be much lower, at $21 trillion. The credit-risk equivalent of the derivative contracts was estimated at $3.3 trillion.
Still, even these scaled-down figures represent huge amounts of money. For perspective, the budget for total expenditure of the United States government during 2012 was $3.5 trillion, and the total current value of the U.S. stock market is an estimated $23 trillion. Meanwhile, the global annual Gross Domestic Product is about $65 trillion.
At least for one type of derivative, credit default swaps, for which the inherent risk is considered high, the higher, nominal value remains relevant. 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". CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.

Usage

Derivatives are used for the following:
  • Hedge or to mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
  • Create option ability where the value of the derivative is linked to a specific condition or event
  • Obtain exposure to the underlying where it is not possible to trade in the underlying
  • Provide leverage, such that a small movement in the underlying value can cause a large difference in the value of the derivative
  • Speculate and make a profit if the value of the underlying asset moves the way they expect
  • Switch asset allocations between different asset classes without disturbing the underlying assets, as part of transition management
  • Avoid paying taxes. For example, an equity swap allows an investor to receive steady payments, e.g. based on SONIA rate, while avoiding paying capital gains tax and keeping the stock.
  • For arbitraging purpose, allowing a riskless profit by simultaneously entering into transactions into two or more markets.

    Mechanics and valuation

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. Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset or a liability at different points throughout its life. Importantly, either party is therefore exposed to the credit quality of its counterparty and is interested in protecting itself in an event of default.
Option products have immediate value at the outset because they provide specified protection over a given time period. One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections and one that extends for a year rather than six months. Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value or expire at no cost .

Hedging

Derivatives allow risk related to 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 because of events unspecified by the contract, such as 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 counter-party 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. The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract 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 for one type of risk, and the counter-party is the insurer for another type of risk.
Hedging also occurs when an individual or institution buys an asset and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then 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.
File:Chicago bot.jpg|right|250px|thumb|Derivatives traders in the pit at the Chicago Board of Trade in 1993
Derivatives trading of this kind may serve the financial interests of certain particular businesses. For example, a corporation borrows a large sum of money at a specific interest rate. The interest rate on the loan reprices every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement, which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money. If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.