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What Are Derivatives?

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Financial Derivatives

New York Financial District

Photo: Mario Tama/Getty Images

Definition: A derivative is a complicated financial contract that gets (derives) its value from an underlying asset. It is, at heart, an agreement between a buyer and a seller that says how much the price of the asset will change over a specific period of time.

The underlying asset can be a commodity, such as oil, gasoline or gold. Many derivatives are based on stocks or bonds. Others use currencies, especially the U.S. dollar, as their underlying asset. Still others use interest rates, such as the yield on the 10-year Treasury note, as their base. These assets can be, but do not have to be, owned by either party to the agreement. This makes derivatives much easier to trade than the asset itself.

Derivatives Trading

It's estimated that derivatives trading is now worth $600 trillion -- ten times more than the total economic output of the entire world. In fact, 92% of the world's 500 largest companies use them to lower risk. For example, a futures contract can promise delivery of raw materials at an agreed-upon price. This way the company is protected if prices rise. They can also write contracts to protect themselves from changes in exchange rates and interest rates. (Source: NYT, Bank Face New Checks on Derivative Trading, January 3, 2013)

In this way, derivatives make future cash flows more predictable. Companies can then forecast their earnings more accurately, boosting stock prices. Businesses then need less cash on hand to cover emergencies, allowing them to reinvest more into their business.

However, the largest part of derivatives trading is done by hedge funds and other investors to gain more leverage. That's because many derivatives only require a small down-payment, called paying on margin. Since many derivatives contracts are offset, or liquidated, by another derivative before coming to term, these traders don't worry about having enough money to pay off the derivative if the market goes against them. If they win, they cash in.

Nearly 85% of all derivatives are traded between two companies or traders that know each other personally. These are called Over the Counter (OTC). The rest are traded on exchanges. These public exchanges set standardized contract terms and specifies the premiums or discounts to the contract price. This standardization improves the liquidity of derivatives by making them more or less exchangeable, thus making them more useful for hedging. Exchanges can also be a clearing house, acting as the actual buyer or seller of the derivative. This makes it safer for traders, since they know the contract will be fulfilled. In 2010, the Dodd-Frank Wall Street Reform Act required most OTC derivatives be moved to an exchange. The details of how to do this are still being worked out. (Source: Deutsche Bourse Group, Intro to Global Derivatives Market)

The largest exchange is the CME Group, which is the result of a merger between the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME, also called the Merc), and the New York Mercantile Exchange (NYMEX). It trades derivatives in all asset classes.

Stock options can also be traded on the NASDAQ or the Chicago Board Options Exchange (CBOE). Futures contracts can also be traded on the Intercontinental Exchange (ICE). It acquired the New York Board of Trade in 2008. It focuses on agricultural and financial contracts, especially coffee, cotton, and currency. These exchanges are regulated by the Commodities Futures Trading Commission or the Securities and Exchange Commission. For a list of exchanges, see Trading Organizations, Clearing Organizations and SEC Self-Regulating Organizations.

Types of Financial Derivatives

Most derivatives require that the agreement be fulfilled, either by an exchange of the asset, a cash payment, or another agreement that offsets the value of the first.

The most notorious are Collateralized Debt Obligations, which were a major cause of the 2008 financial crisis. These bundle debt, like auto loans, credit card debt, or mortgages, into a security whose value is based on the promised repayment of the loans. There are two major types. Asset-backed commercial paper is based on corporate and business debt. Mortgage-backed securities are based on mortgages. When the housing market collapsed in 2006, so did the value of the MBS and then the ABCP.

The most common type of derivative is a swap. This is simply an agreement to exchange one asset (or debt) for a similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps or interest-rate swaps. For example, a trader might sell a stock in the U.S. and buy it in a foreign currency to hedge currency risk. These are OTC, or not traded on an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-rate payment stream of another company's bond.

The most infamous of these swaps were credit default swaps because they also helped cause 2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate debt or mortgage-backed securities (MBS). When the MBS collapsed, there wasn't enough capital to pay off the CDS holders. That's why the Federal government had to nationalize AIG. These are now being put under regulation of the CFTC.

Forwards are another OTC derivative. They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. Forwards are very customized between the two parties. They are done to hedge risk in commodities, interest rates, exchange rates or equities. (Source: CBOE, Overview of Derivatives)

Another influential type of derivative are futures contracts. These are traded on exchanges. The most widely used are commodities futures. Of these, the most important are oil price futures. That's because they set the price of oil and, ultimately, gasoline.

Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain price and date. The most widely-used are stock options. The right to buy is a call option and the right to sell a stock is a put option. These are traded on exchanges.

Risks of Derivatives

The biggest risk is that it's nearly impossible to know the true value of any derivative. That's because it's based on the value of another underlying asset, which can also be difficult to price. That's the reason mortgage-backed securities were so deadly to the economy -- no one, not even the computer programmers who created them, knew what their price was when housing prices dropped. Banks become unwilling to trade them because they couldn't value them.

 

Another risk is that the same thing that makes them so attractive, and that's leverage. For example, futures traders are only required to put 2-10% of the contract into a margin account to maintain ownership. If the value of the underlying asset drops, they must add money to the margin account to maintain that percentage until the contract expires or is offset. If the commodity price keeps dropping, covering the margin account can lead to enormous losses. For examples, see CFTC Education Center.

The worst part of derivatives is their time restriction. It's one thing to bet that gas prices will go up. It's another thing entirely to know exactly when that will happen. No one who bought MBS thought housing prices would drop -- they hadn't since the Great Depression. They also thought they were protected by CDS. The leverage involved meant that, when losses occurred, they were magnified throughout the entire economy. Furthermore, they were unregulated and not sold on exchanges. This is a risk specific to OTC derivatives.

Last but not least is the potential for scams. The Bernie Madoff ponzi scheme was built on derivatives. Fraud is rampant in the derivatives market. To find out the latest scams in commodities futures, see this CTFC Advisory. Article updated April 2, 2013

Also Known As: Financial Derivatives, Trading Derivatives

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