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Derivative (finance)
Encyclopedia
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.
Under U.S. law and the laws of most developed countries, derivatives have special legal exemptions which make them a particularly attractive legal form through which to extend credit. However, the strong creditor protections afforded to derivatives counterparties--in combination with their complexity and lack of transparency--can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy. Financial reforms within the U.S. since the financial crisis have only served to reinforce special protections for derivatives--including greater access to government guarantees--while minimizing disclosure to broader financial markets.
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 (e.g., forward
, option
, swap
); the type of underlying asset (e.g., equity derivative
s, foreign exchange derivative
s, interest rate derivative
s, commodity derivatives, or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter
); and their pay-off profile.
Derivatives can be used for speculating purposes ("bets") or to hedge
("insurance"). For example, a speculator may sell deep in-the-money naked call
s on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate
of two currencies.
Third parties can use publicly available derivatives prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.
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 (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 have) 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 counter-party is the insurer (risk taker) for another type of risk.
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. 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.
Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate. The rate of interest on the loan resets 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 (FRA), 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.
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 regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.
Swaps can basically be categorized into two types:
Some common examples of these derivatives are:
Other examples of underlying exchangeables are:
In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant
.
However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding 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.
OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. And most of the model's results are input-dependant (meaning the final price depends heavily on how we derive the pricing inputs).
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).
, or borrowing. Derivatives allow investor
s 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:
. Different types of derivatives have different levels of counter-party risk. 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 that 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.
in Berkshire Hathaway
's 2002 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)
.
(See Berkshire Hathaway Annual Report for 2002)
, an industry self-regulatory body, Gary Gensler
, the chairman of the Commodity Futures Trading Commission
which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice
is looking into derivatives, too. The department’s antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."
Over-the-counter dealing will be less common as the 2010 Dodd-Frank Wall Street Reform Act comes into effect. The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on derivatives. To implement Dodd-Frank, the CFTC developed new rules in at least 30 areas. The Commission determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a certain type of swap contract.
Under U.S. law and the laws of most developed countries, derivatives have special legal exemptions which make them a particularly attractive legal form through which to extend credit. However, the strong creditor protections afforded to derivatives counterparties--in combination with their complexity and lack of transparency--can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy. Financial reforms within the U.S. since the financial crisis have only served to reinforce special protections for derivatives--including greater access to government guarantees--while minimizing disclosure to broader financial markets.
One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange
Dojima Rice Exchange
The Dōjima Rice Exchange , located in Osaka, was the center of Japan's system of rice brokers, which developed independently and privately in the Edo period and would be seen as the forerunners to a modern banking system...
since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
, option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, swap
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
); the type of underlying asset (e.g., equity derivative
Equity derivative
In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively...
s, foreign exchange derivative
Foreign exchange derivative
A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. For detail see:...
s, interest rate derivative
Interest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate...
s, commodity derivatives, or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
); and their pay-off profile.
Derivatives can be used for speculating purposes ("bets") or to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
("insurance"). For example, a speculator may sell deep in-the-money naked call
Naked call
A naked call occurs when a speculator writes a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk as opposed to a naked put where the maximum loss occurs if the stock falls to zero...
s on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
of two currencies.
Third parties can use publicly available derivatives prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.
Usage
Derivatives are used by investors to:- provide leverageLeverage (finance)In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
(or gearing), 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 (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);
- hedgeHedge (finance)A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
or 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; - obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivativesWeather derivativesWeather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions...
); - create optionOption (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).
Hedging
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheatWheat
Wheat is a cereal grain, originally from the Levant region of the Near East, but now cultivated worldwide. In 2007 world production of wheat was 607 million tons, making it the third most-produced cereal after maize and rice...
farmer and a miller
Miller
A miller usually refers to a person who operates a mill, a machine to grind a cereal crop to make flour. Milling is among the oldest of human occupations. "Miller", "Milne" and other variants are common surnames, as are their equivalents in other languages around the world...
could sign a futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
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
Revocation
Revocation is the act of recall or annulment. It is the reversal of an act, the recalling of a grant, or the making void of some deed previously existing.-Contract law:...
on the contract. Although a third party, called a clearing house
Clearing house (finance)
A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
, 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 (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 have) 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 counter-party is the insurer (risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
, 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 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.
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
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.
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 look 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
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
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
Nick Leeson
Nicholas "Nick" Leeson is a former derivatives broker whose fraudulent, unauthorized speculative trading caused the collapse of Barings Bank, the United Kingdom's oldest investment bank, for which he was sent to prison...
, a trader at Barings Bank
Barings Bank
Barings Bank was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost £827 million due to speculative investing, primarily in futures contracts, at the bank's Singapore office.-History:-1762–1890:Barings Bank was founded in 1762 as the...
, 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 US$1.3 billion loss that bankrupted the centuries-old institution.
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:- Over-the-counterOver-the-counter (finance)Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(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 swapsSwap (finance)In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
, forward rate agreementForward rate agreementIn finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used...
s, and exotic optionExotic optionIn finance, an exotic option is a derivative which has features making it more complex than commonly traded products . These products are usually traded over-the-counter , or are embedded in structured notes....
s 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 fundHedge fundA hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s. 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 SettlementsBank for International SettlementsThe Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
, the total outstanding notional amount is US$684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contractsInterest rate derivativeAn interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate...
, 8% are credit default swaps (CDS)Credit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
, 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 counter-party. Therefore, they are subject to counter-party risk, like an ordinary contractContractA contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
, since each counter-party relies on the other to perform.
- Exchange-traded derivative contractExchange-traded derivative contractExchange-traded derivative contracts are standardized derivative contracts that are transacted on an organized futures exchange....
s (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. 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 derivatives exchanges (by number of transactions) are the Korea ExchangeKorea ExchangeKorea Exchange is the sole securities exchange operator in South Korea. It is headquartered in Busan, and has an office for cash markets and market oversight in Seoul.- History :...
(which lists KOSPIKOSPIThe Korea Composite Stock Price Index or KOSPI is the index of all common stocks traded on the Stock Market Division—previously, Korea Stock Exchange—of the Korea Exchange....
Index Futures & Options), EurexEurexEurex is one of the world's leading derivatives exchanges, providing European benchmark derivatives featuring open and low-cost electronic access globally...
(which lists a wide range of European products such as interest rate & index products), and CME GroupCME GroupThe CME Group bases prices for US gasoline on Brent Crude rather than West Texas Intermediate Crude , which many believe is responsible for artificially high gas prices for US consumers...
(made up of the 2007 merger of the Chicago Mercantile ExchangeChicago Mercantile ExchangeThe Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
and the Chicago Board of TradeChicago Board of TradeThe Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
and the 2008 acquisition of the New York Mercantile ExchangeNew York Mercantile ExchangeThe New York Mercantile Exchange is the world's largest physical commodity futures exchange. It is located at One North End Avenue in the World Financial Center in the Battery Park City section of Manhattan, New York City...
). According to BIS, the combined turnover in the world's derivatives exchanges totaled 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, warrantsWarrant (finance)In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
(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
Some of the common variants of derivative contracts are as follows:- ForwardsForward contractIn finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
:A tailored contract between two parties, where payment takes place at a specific time in the future at today's pre-determined price. - FuturesFutures-Finance:*Futures contract, a tradable financial contract*Futures exchange, a financial market where futures contracts are traded*Futures , an American finance magazine-Music:*Futures , a 2004 release by Jimmy Eat World...
: are contracts to buy or sell an assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
on or before a future date at a price specified today. A futures contract differs from a forward contract in the manner that while the former is a standardized contract written by a clearing houseClearing house (finance)A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
that operates an exchange where the contract can be bought and sold, the latter is a non-standardized contract written by the parties themselves. - OptionsOption (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
are contracts that give the owner the right, but not the obligation, to buy (in the case of a call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
) or sell (in the case of a put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
) an asset. The price at which the sale takes place is known as the strike priceStrike priceIn options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
, 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 counter-party has the obligation to carry out the transaction. Options are of two types- Call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
and Put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
. The buyer of a Call option although has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option although has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. - Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options as well, known as Warrant (finance)Warrant (finance)In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
. These are generally traded over-the-counter. - SwapSwap- Finance :* Swap , a derivative in which two parties agree to exchange one stream of cash flows against another* Barter- Technology :* Swap space, related to a computer's virtual memory subsystem...
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 exchangeCommodities exchangeA commodities exchange is an exchange where various commodities and derivatives products are traded. Most commodity markets across the world trade in agricultural products and other raw materials and contracts based on them...
, stocks or other assets. Another term which is commonly associated to Swap is SwaptionSwaptionA swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps....
which is basically an option on the forward Swap. Similar to a Call and Put option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand, in case of a receiver Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption on the other hand is an option to pay fixed and receive floating.
Swaps can basically be categorized into two types:
- Interest Rate SwapInterest rate swapAn interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
: These basically necessitate swapping only interest associated cash flows in the same currency, between two parties. - Currency swapCurrency swapA currency swap is a foreign-exchange agreement between two parties to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage...
: In this kind of swapping,the cash flow between the two parties includes both, principal and interest. Also the money which is being swapped is in different currency for both parties.
Examples
The overall derivatives market has five major classes of underlying asset:- interest rate derivatives (the largest)
- foreign exchange derivativeForeign exchange derivativeA Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. For detail see:...
s - credit derivatives
- equity derivatives
- commodity derivatives
Some common examples of these derivatives are:
| UNDERLYING | CONTRACT TYPES | ||||
|---|---|---|---|---|---|
| Exchange-traded futures | Exchange-traded options | OTC swap | OTC forward | OTC option | |
| Equity | DJIA Dow Jones Industrial Average The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow... Index future Single-stock future Single-stock futures Single-stock futuresIn finance, a single-stock futures is a type of futures contracts between two parties to exchange a specified number of stocks in company for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange... |
Option on DJIA Dow Jones Industrial Average The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow... Index future Single-share option |
Equity swap Equity swap An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as... |
Back-to-back Repurchase agreement Repurchase agreement A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively... |
Stock option Warrant Warrant (finance) In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date.... Turbo warrant Turbo warrant Turbo warrant is a kind of stock option. Specifically, it is a barrier option of the Down and Out type. It is similar to a vanilla contract, but with two additional features: It has a low vega, meaning that the option price is much less affected by the implied volatility of the stock market, and it... |
| Interest rate | Eurodollar future Euribor future |
Option on Eurodollar future Option on Euribor future |
Interest rate swap Interest rate swap An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another... |
Forward rate agreement Forward rate agreement In finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used... |
Interest rate cap and floor Interest rate cap and floor 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 strike price... Swaption Swaption A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.... Basis swap Basis swap A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A basis swap functions as a floating-floating interest rate swap under which the floating rate payments are referenced to different bases.... Bond option Bond option In finance, a bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. These instruments are typically traded OTC.... |
| Credit | Bond future | Option on Bond future | Credit default swap Credit default swap A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default... Total return swap Total return swap Total return swap, or TRS , or total rate of return swap, or TRORS, is a financial contract that transfers both the credit risk and market risk of an underlying asset.- Contract definition :... |
Repurchase agreement Repurchase agreement A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively... |
Credit default option Credit default option In finance, a default option, credit default swaption or credit default option is an option to buy protection or sell protection as a credit default swap on a specific reference credit with a specific maturity... |
| Foreign exchange | Currency future Currency future A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar... |
Option on currency future | Currency swap Currency swap A currency swap is a foreign-exchange agreement between two parties to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage... |
Currency forward | Currency option |
| Commodity | WTI crude oil futures | Weather derivatives Weather derivatives 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 adverse or unexpected weather conditions... |
Commodity swap Commodity swap A commodity swap is an agreement where by a floating price based on an underlying commodity is exchanged for a fixed price over a specified period.A Commodity swap is similar to a Fixed-Floating Interest rate swap... |
Iron ore forward contract | Gold option |
Other examples of underlying exchangeables are:
- Property (mortgage) derivativesProperty derivativesA property derivative is a financial derivative whose value is derived from the value of an underlying real estate asset. In practice, because real estate assets fall victim to market inefficiencies and are hard to accurately price, property derivative contracts are typically written based on a...
- Economic derivatives that pay off according to economic reports as measured and reported by national statistical agencies
- Freight derivatives
- Inflation derivativesInflation derivativesIn finance, inflation derivative refers to an over-the-counter and exchange-traded derivative that is used to transfer inflation risk from one counterparty to another...
- Weather derivativesWeather derivativesWeather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions...
- Insurance derivatives
- Emissions derivatives
Economic function of the derivative market
Some of the salient economic functions of the derivative market include:- Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlyingUnderlyingIn finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices. - The derivatives market relocates risk from the people who prefer risk aversionRisk aversionRisk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....
to the people who have an appetite for risk. - The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot marketSpot marketThe spot market or cash market is a public financial market, in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market in which delivery is due at a later date...
. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk. - As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculationSpeculationIn finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
can be controlled, resulting in a more meticulous environment. - A significant accompanying benefit which is a consequence of derivatives trading is that it acts as a facilitator for new Entrepreneurs. The derivatives market has a history of alluring many optimistic, imaginative and well educated people with an entrepreneurial outlook, the benefits of which are colossal.
In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant
Market participant
The term market participant is used in United States constitutional law to describe a U.S. State which is acting as a producer or supplier of a marketable good or service. When a state is acting in such a role, it may permissibly discriminate against non-residents. This principle was established by...
.
Valuation
Market and arbitrage-free prices
Two common measures of value are:- Market priceMarket priceIn economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
, i.e., the price at which traders are willing to buy or sell the contract; - ArbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricingRational pricingRational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...
.
Determining the market price
For exchange-traded derivatives, market price is usually transparent, 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 can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities.However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process
Stochastic process
In probability theory, a stochastic process , or sometimes random process, is the counterpart to a deterministic process...
of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options
Valuation of options
In finance, a price is paid or received for purchasing or selling options. This price can be split into two components.These are:* Intrinsic Value* Time Value-Intrinsic Value:...
is the Black–Scholes formula, which is based on the assumption that the cash flows from a European stock option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
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.
OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. And most of the model's results are input-dependant (meaning the final price depends heavily on how we derive the pricing inputs).
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).
Risk
The use of derivatives can result in large losses because of the use of leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
, or borrowing. Derivatives allow investor
Investor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
s 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:
- American International GroupAmerican International GroupAmerican International Group, Inc. or AIG is an American multinational insurance corporation. Its corporate headquarters is located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in...
(AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on Credit Default SwapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s (CDS). The US federal government then gave the company US$85 billion in an attempt to stabilize the economy before an imminent stock market crashLate-2000s financial crisisThe late-2000s financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s...
. It was reported that the gifting of money was necessary because over the next few quarters, the company was likely to lose more money. - The loss of US$7.2 BillionJanuary 2008 Société Générale trading loss incidentIn January 2008, the bank Société Générale lost approximately €4.9 billion closing out positions over three days of trading beginning January 21, 2008, a period in which the market was experiencing a large drop in equity indices. The bank states these positions were fraudulent transactions created...
by Société GénéraleSociété GénéraleSociété Générale S.A. is a large European Bank and a major Financial Services company that has a substantial global presence. Its registered office is on Boulevard Haussmann in the 9th arrondissement of Paris, while its head office is in the Tours Société Générale in the business district of La...
in January 2008 through mis-use of futures contracts. - The loss of US$6.4 billion in the failed fund Amaranth AdvisorsAmaranth AdvisorsAmaranth Advisors LLC was an American investment adviser managing multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. The firm had up to $9 billion in assets under management and collapsed in September 2006 after losing in excess of $5 billion on...
, 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 ManagementLong-Term Capital ManagementLong-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
in 1998. - The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.
- The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings BankBarings BankBarings Bank was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost £827 million due to speculative investing, primarily in futures contracts, at the bank's Singapore office.-History:-1762–1890:Barings Bank was founded in 1762 as the...
. - UBS AG, Switzerland’s biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September, 2011.
Counter-party risk
Some derivatives (especially swaps) expose investors to counter party riskCounter party risk
Counterparty risk, otherwise known as default risk, is the risk that an organization does not pay out on a credit derivative, credit default swap, credit insurance contract, or other trade or transaction when it is supposed to.[2] Even organizations who think that they have hedged their bets by...
. Different types of derivatives have different levels of counter-party risk. 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 that 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.
Large notional value
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 BuffettWarren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
in Berkshire Hathaway
Berkshire Hathaway
Berkshire Hathaway Inc. is an American multinational conglomerate holding company headquartered in Omaha, Nebraska, United States, that oversees and manages a number of subsidiary companies. The company averaged an annual growth in book value of 20.3% to its shareholders for the last 44 years,...
's 2002 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)
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 DepressionGreat Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
.
(See Berkshire Hathaway Annual Report for 2002)
Benefits
The use of derivatives also has its benefits:- Derivatives facilitate the buying and selling of risk, and many financial professionals consider this to have a positive impact on the economic systemEconomic systemAn economic system is the combination of the various agencies, entities that provide the economic structure that defines the social community. These agencies are joined by lines of trade and exchange along which goods, money etc. are continuously flowing. An example of such a system for a closed...
. 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 utilityUtilityIn economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
.
Government regulation
In the context of a 2010 examination of the ICE TrustIntercontinentalExchange
IntercontinentalExchange, Inc., known as ICE, is an American financial company that operates Internet-based marketplaces which trade futures and over-the-counter energy and commodity contracts as well as derivative financial products...
, an industry self-regulatory body, Gary Gensler
Gary Gensler
Gary Gensler is the chairman of the U.S. Commodity Futures Trading Commission under President Barack Obama.Gensler was Undersecretary of the Treasury and Assistant Secretary of the Treasury in the United States. Barack Obama selected him to lead the Commodity Futures Trading Commission, which has...
, the chairman of the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice
United States Department of Justice
The United States Department of Justice , is the United States federal executive department responsible for the enforcement of the law and administration of justice, equivalent to the justice or interior ministries of other countries.The Department is led by the Attorney General, who is nominated...
is looking into derivatives, too. The department’s antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."
Over-the-counter dealing will be less common as the 2010 Dodd-Frank Wall Street Reform Act comes into effect. The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on derivatives. To implement Dodd-Frank, the CFTC developed new rules in at least 30 areas. The Commission determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a certain type of swap contract.
Glossary
- Bilateral nettingBilateral NettingBilateral netting is a legally enforceable arrangement between a bank and a counterparty that creates a single legal obligation covering all included individual contracts...
: 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. - Credit derivativeCredit derivativeIn finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
: A contract that transfers credit riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s, credit linked 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 contractExchange-traded derivative contractExchange-traded derivative contracts are standardized derivative contracts that are transacted on an organized futures exchange....
s: Standardized derivative contracts (e.g., futures contractFutures contractIn finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s and optionsOption (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
) that are transacted on an organized futures exchangeFutures exchangeA futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
. - 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.
- Notional amountNotional amountThe notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
: 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. - Over-the-counterOver-the-counter (finance)Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges. - 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 1Tier 1 capitalTier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...
plus tier 2 capitalTier 2 capitalTier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earningsRetained earningsIn accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or...
, and minority interestMinority interestMinority interest in business is an accounting concept that refers to the portion of a subsidiary corporation's stock that is not owned by the parent corporation...
s in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debtSubordinated debtIn finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....
, intermediate-term preferred stockPreferred stockPreferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
, cumulative and long-term preferred stock, and a portion of a bank’s allowance for loan and lease losses.
See also
- Dual currency depositDual currency depositIn finance, a dual currency deposit is a derivative instrument which combines a money market deposit with a currency option to provide a higher yield than that available for a standard deposit. There is a higher risk than with the latter - you can receive less funds than originally deposited and...
- Forward contractForward contractIn finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
- FX Option