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Derivative security
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In finance, a derivative security is a contract that specifies the rights and obligations between the 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.

Contents
1 Properties
2 Cash flow
3 Types of derivatives
4 Glossary
5 Valuation
5.1 BIS survey
6 Usages
6.1 General Electric
7 Opinions
8 See also
8.1 Associations
8.2 Lists
9 External links
9.1 Associations
9.2 Risk
9.3 Articles

Properties
A derivate can have a large number of properties, so that its value depends on many factors. The terms and payments can
be derived from the price of a security or commodity, a published statistics, an event (such as default on payment), or
something else.

Derivatives which are fully standardized like futures and many options are generally traded through a securities exchange
or futures exchange. "Over-the-counter" derivatives are negotiated privately between parties, and the terms can generally
be customized to meet the parties' needs. Those standardized contracts traded on an exchange will generally have much
greater liquidity.

The fundamental nature of a derivative is that unlike a bond, as in a Treasury bond, or a stock, or even physical stock or
commodity (ie: some raw material, product), a derivative has no physicalistic purpose or reason for existence.

Cash flow
The payments between the parties may be determined by:

the price of some other, independently traded asset in the future (e.g., a common stock);
the level of an independently determined index (e.g., a stock index or heating-degree-days);
the occurrence of some well-specified event (e.g., a company defaulting);

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an interest rate;
an exchange rate;
or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a
predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the
derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the
contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or
commodity directly.

Types of derivatives
Common examples of derivatives are: (with the notional amount on open OTC contracts in Dec 2003 according to the BIS
in $ billions) ([1] (http://www.bis.org/publ/regpubl.htm) )

Forwards
Forward rate agreement (14,399)
Forward starting swap
Futures contract

Options
Credit default option
Exotic interest rate option
Foreign exchange option (6,806)
Interest rate option (25,756)
Interest rate cap
Stock option (3,186)
Swaption
Turbo warrant
Warrant (finance)

Swap
Basis swap
Equity swap
Credit default swap
Credit-linked note
Currency swap (7,939)
Interest rate swap (137,277)
Total return swap

By underlying security:

Currency derivatives
Equity derivatives
Interest rate derivatives
Credit derivatives

Some less common examples are:

Economic derivatives which pay off according to economic reports ([2] (http://biz.yahoo.com/c/e.html) ) as
measured and reported by national statistical agencies
Freight derivative
Weather derivatives

Glossary

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From: Quarterly Derivatives Fact Sheet (http://www.occ.treas.gov/deriv/deriv.htm)

Bilateral Netting: A legally enforceable arrangement between a bank and a counterparty 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 Derivative: A contract which transfers credit risk from a protection buyer to a credit protection seller. Credit
derivative products can take many forms, such as credit default options, credit limited 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 Contracts: Standardized derivative contracts (e.g. futures and options) that are
transacted on an organized exchange.

Gross Negative Fair Value: The sum total of the fair values of contracts where the bank owes money to its
counterparties, without taking into account netting. This represents the maximum losses the bank’s counterparties
would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the
counterparties.

Gross Positive Fair Value: The sum total of the fair values of contracts where the bank is owed money by its
counterparties, without taking into account netting. This represents the maximum losses a bank could incur if all its
counterparties default and there is no netting of contracts, and the bank holds no counterparty 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 Amount: The nominal or face amount that is used to calculate payments made on swaps and other risk
management products. This amount generally does not change hands and is thus referred to as notional.

Over-the-Counter Derivative Contracts: Privately negotiated derivative contracts that are transacted off organized
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 1 plus tier 2 capital. Tier 1 capital consists of common shareholders
equity, perpetual preferred shareholders equity with noncumulative dividends, retained earnings, and minority
interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt,
intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a bank’s allowance
for loan and lease losses.

Valuation
The central topic of financial mathematics is the fair valuation of derivatives. Whereas "fair" refers to the absence of
arbitrage, meaning that no riskless profits can be made by trading in assets. A key equation is the Black-Scholes formula,
that made it possible to replicate a stock option by a continuous buying and selling strategy in the plain stock. Crucial to
the valuation of derivatives is also the stochastics of the underlying assets, typically expressed as a stochastic process.

BIS survey

The Swiss BIS bank in their Regular OTC Derivatives Market Statistics (http://www.bis.org/publ/otc_hy0412.htm) from 6
December 2004 that, in the middle of 2004, notional amounts on outstanding Over The Counter (OTC) contracts had a

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notional amount of $220.058 trillion with a gross market value of $6.394 trillion.

Usages
One 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 (or hedges) the risk that the price will rise or fall, and the speculator
accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop
that he will grow; the speculator will make a profit if the price rises, but also risks making a loss if the price falls.

Of course, speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the
value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives
traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying
securities.

Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership
of the underlying is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position.

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 index futures. Through a combination of poor judgment on his part, lack of
oversight by management, a naive regulatory environment 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, the Policy Analysis Market, noting that
futures markets are unusually efficient at gathering and processing information. The idea was halted due to political
uproar.

General Electric

This company uses derivatives to "match funding" (GE webcast on derivatives

(http://www.ge.com/en/company/investor/webcast/webcast_05062005.htm) ) to mitigate interest rate and currency risk, to
lock in material cost. It's 100% for planning purposes, not to earn money, so it's not a hedge fund. 90% of all derivatives
revenue made by derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable planning.

On 05/06-2005 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003 ( Revised 2004
10K (PDF, 787 KB) (http://www.ge.com/en/company/investor/secreport/ge_10ka_2004.htm) ).

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

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 ([3] (http://news.bbc.co.uk/1/hi/business/2817995.stm) ). 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.

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.

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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.

See also
Derivatives markets
Financial engineering
Financial mathematics
Herfindahl index

Associations

International Swaps & Derivatives Association

Lists

List of finance topics

External links
Associations

ISDA: Website of International Swaps and Derivatives Association (http://www.isda.org/)

OCC - Comptroller of the Currency, Administrator of National Banks (http://www.occ.treas.gov/)
Bank for International Settlements (http://www.bis.org/)

Risk

Quantnotes.com (http://www.quantnotes.com/fundamentals/) - introductory articles covering mathematical finance

Riskglossary.com (http://www.riskglossary.com/) - an online glossary, encyclopedia, and resource locator
Riskworx.com (http://www.riskworx.com/res_inst.php) - discussion of the application and theory of derivatives

Articles

BBC NEWS | Business | Buffett warns on investment 'time bomb'

(http://news.bbc.co.uk/1/hi/business/2817995.stm)

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