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Derivative security

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In finance, a derivative security is security which takes the form of a contract that specifies the rights and obligations between and issuer of the security and the holder to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event.

Other derivative products in the world of financial services do not take the form of securities but are in the form of a bi-lateral contract either known as (i) an over-the-counter ( or OTC derivative ), or in the form of (ii) an exchange-traded derivative. The economic derivative product embedded into either of the above or into a derivative security may be the same or different, as the differences between these 3 products are in their legal form.

Another way of defining a derivative is that it is a financial product whose value is determined (derived) from one or more other securities, commodities, published statistics, or events. The value is influenced by the features of the derivative contract, which may include the timing of the contract fulfillment, the value of the underlying security or commodity, and other factors such as volatility.

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 index or heating-degree-days)
  • the occurrence of some well-specified event (e.g., a company defaulting)

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.

Contents
1 Types of derivatives
2 Levels
3 Usages, opinions
4 See also
5 External links

Types of derivatives

Common examples of derivatives are: (with notional amount of open OTC contracts in Dec 2003 in paranthesis)

Some less common, but intriguing, examples are:

  • Economic derivatives which pay off according to the state of the economy as measured by national statistical agencies
  • Weather derivatives

Levels

Derivatives are one of the most rapidly growing and changing areas of modern finance. According to the BIS (Bank for International Settlements), as of December 2003, the "total estimated notional amount of outstanding OTC contracts stood at $197.177 trillion" while "exchange-traded contracts" were $36.750 trillion. ([1])

Usages, opinions

The most common use of derivative securities is as a tool to transfer risk. For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer receives cash upfront and he knows for certain the revenue he will get for the crop that he will grow; the speculator pays for the right to profit from price rises, but also pays the cost if the price falls.

Because derivative securities offer the possibility of large rewards, many individuals have the strong desire to invest in derivative securities. Most financial planners caution against this, pointing out that an investor in derivative securities often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor[2]. One should keep in mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative

The central topic of financial mathematics is the fair valuation of derivatives. One key equation used to value derivatives is the Black-Scholes Equation.

Economists generally believe that derivatives have a positive impact on the economic system by allowing the buying and selling of risk. However, many economists are worried that derivatives may cause an economic crisis at some point in the future. Since someone loses money while someone else gains money with a derivative security, under normal circumstances, trading in derivatives should not adversely affect the economic system.

There is the danger, however, that someone would lose so much money that they would be unable to pay for their losses. This might cause chain reactions which could create an economic crisis. In 2002, legendary investor Warren Buffett commented in an interview with the New York Times that he had accumulated his wealth without the use of derivatives and that he regarded them as 'financial weapons of mass destruction', an allusion to the phrase 'weapons of mass destruction' relating to physical weapons which had wide currency at the time.

Although there have been instances of massive losses, most notably by Long-Term Capital Management, these have not had repercussive effects. 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.

This kind of investment gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in derivatives. Through a combination of poor judgment on his part, lack of oversight by management, and unfortunate outside events, Leeson incurred a 1.3 billion dollar loss that bankrupted the centuries old financial institution.

DARPA also examined the idea of developing a futures market for world events, noting that futures markets are unusually efficient at gathering and processing information. The idea was halted due to political uproar.

See also

External links

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