derivate intro

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A derivative is afinancial instrumentwhose value is based on one or more underlying

assets. In practice, it is acontractbetween two parties that specifies conditions (especially

the dates, resulting values of the underlying variables, and notional amounts) under which

payments are to be made between the parties.[1][2]The most common types of derivatives

are: forwards, futures, options, and swaps. The most common underlying assets include:commodities, stocks, bonds, interest rates and currencies.

Under US law and the laws of most other developed countries, derivatives have special legal

exemptions that make them a particularly attractive legal form to extend credit.[3]The strong

creditor protections afforded to derivatives counterparties, in combination with their

complexity and lack of transparency however, can cause capital markets to underprice credit

risk. This can contribute to credit booms, and increase systemic risks.[3]Indeed, the use of

derivatives to conceal credit risk from third parties while protecting derivative counterparties

contributed to the financial crisis of 2008 in the United States.[3][4]

Financial reforms within the US since the financial crisis have served only to reinforce

special protections for derivatives, including greater access to government guarantees, while

minimizing disclosure to broader financial markets.[5]

One of the oldest derivatives is rice futures, which have been traded on theDojima Rice

Exchangesince the eighteenth century.[6]Derivatives are broadly categorized by the

relationship between the underlying asset and the derivative (such asforward,option,swap);

the type of underlying asset (such asequity derivatives,foreign exchange

derivatives,interest rate derivatives, commodity derivatives, orcredit derivatives); the market

in which they trade (such as exchange-traded orover-the-counter); and their pay-off profile.Derivatives can be used forspeculation("bets") or tohedge("insurance"). For example, a

speculator may selldeep in-the-moneynaked callson 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 theexchange rateof two

currencies.

Usage

Derivatives are used by investors for the following:

provideleverage(or gearing), such that a small movement in the underlying value can

cause a large difference in the value of the derivative;[8]

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);
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erivative_(finance)#cite_note-Secret-3http://en.wikipedia.org/wiki/Derivative_(finance)#cite_note-1http://en.wikipedia.org/wiki/Derivative_(finance)#cite_note-1http://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Financial_instrument


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hedgeor 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;[9]

obtain exposure to the underlying where it is not possible to trade in the underlying

(e.g.,weather derivatives);[10]

createoptionability where the value of the derivative is linked to a specific condition or

event (e.g. the underlying reaching a specific price level).

Hedging

Main article:Hedge (finance)

Derivatives allow risk related to the price of the underlying asset to be transferred from one

party to another. For example, awheatfarmer and amillercould sign afutures contractto

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 willrenegeon the contract. Although a third party, called aclearing 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 hascoupon 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.
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Derivatives traders at theChicago Board of Trade

Derivatives can serve legitimate business purposes. For example, a corporation borrows a

large sum of money at a specific interest rate.[11]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 sixmonths. 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 anotional amountof money.[12]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 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 forarbitrageopportunities, 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 whenNick Leeson,a trader atBarings 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 theKobe earthquake, Leeson incurred a US$1.3

billion loss that bankrupted the centuries-old institution.[13]

Types

[edit]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:
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contract is a standardized contract written by aclearing housethat operates an

exchange where the contract can be bought and sold; the forward contract is a non-

standardized contract written by the parties themselves.

3. Optionsare contracts that give the owner the right, but not the obligation, to buy (in

the case of acall option) or sell (in the case of aput option) an asset. The price atwhich the sale takes place is known as thestrike price, and is specified at the time

the parties enter into the option. The option contract also specifies a maturity date. In

the case of aEuropean option, the owner has the right to require the sale to take

place on (but not before) the maturity date; in the case of anAmerican 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 optionandput option. The

buyer of a Call option 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 noobligation whatsoever to carry out this right. Similarly, the buyer of a Put option 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.

4. Binary optionsare contracts that provide the owner with an all-or-nothing profit

profile.

5. 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 asWarrant (finance). These are generally traded over-the-counter.

6. Swapsare 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 exchange, stocks or other assets. Another term which is

commonly associated to Swap isSwaptionwhich 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 swap: These basically necessitate swapping only interest associated cash

flows in the same currency, between two parties.

Currency swap: 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.[17]

Some common examples of these derivatives are the following:

UNDERLYING CONTRACT TYPES
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Exchange-

traded

futures

Exchange-

traded optionsOTC swap OTC forward OTC option

Equity

DJIAIndex

future

Single-stock

future

Option

onDJIAIndex

future

Single-share

option

Equity swap

Back-to-back

Repurchase

agreement

Stock option

Warrant

Turbo

warrant

Interest rate

Eurodollar

future

Euribor future

Option on

Eurodollar future

Option on

Euribor future

Interest rate

swap

Forward rate

agreement

Interest rate

cap and

floor

Swaption

Basis swap

Bond option

Credit Bond futureOption on Bond

future

Credit

default swap

Total returnswap

Repurchase

agreement

Credit

default

option

Foreign

exchange

Currency

future

Option on

currency future

Currency

swap

Currency

forward

Currency

option

CommodityWTI crude oil

futures

Weather

derivative

Commodity

swap

Iron ore

forward

contract

Gold option

Economic function of the derivative market

Some of the salient economic functions of the derivative market include:

1. Prices in a structuredderivative marketnot only replicate the discernment of the

market participants about the future but also lead the prices ofunderlyingto the

professed future level. On the expiration of thederivative contract, the prices of

derivatives congregate with the prices of the underlying. Therefore, derivatives are

essential tools to determine both current and future prices.
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swaphttp://en.wikipedia.org/wiki/Interest_rate_swaphttp://en.wikipedia.org/wiki/Turbo_warranthttp://en.wikipedia.org/wiki/Turbo_warranthttp://en.wikipedia.org/wiki/Warrant_(finance)http://en.wikipedia.org/wiki/Stock_optionhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Repurchase_agreementhttp://en.wikipedia.org/wiki/Equity_swaphttp://en.wikipedia.org/wiki/Dow_Jones_Industrial_Averagehttp://en.wikipedia.org/wiki/Single-stock_futureshttp://en.wikipedia.org/wiki/Single-stock_futureshttp://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average


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2. The derivatives market relocates risk from the people who preferrisk aversionto the

people who have an appetite for risk.

3. 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

underlyingSpot market. The dominant factor behind such an escalation is increasedparticipation by additional players who would not have otherwise participated due to

absence of any procedure to transfer risk.

4. 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,speculationcan be controlled, resulting in a more meticulous

environment.

5. A significant accompanying benefit which is a consequence of derivatives trading is

that it acts as a facilitator for newEntrepreneurs. The derivatives market has ahistory 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 derivativeMarket participant.[18]

Valuation

Total world derivatives from 19982007[19]

compared to total world wealth in the year 2000[20]

[edit]Market and arbitrage-free prices

Two common measures of value are:

Market price, i.e., the price at which traders are willing to buy or sell the contract;
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Arbitrage-free price, meaning that no risk-free profits can be made by trading in these

contracts; seerational pricing.

[edit]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.

[edit]Determining the arbitrage-free price

SeeList of finance topics# Derivatives pricing.

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 offinancial

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 thestochastic processof the price of the

underlying asset is often crucial. A key equation for the theoreticalvaluation of optionsis

theBlackScholes formula, which is based on the assumption that the cash flows from a

European stockoptioncan be replicated by a continuous buying and selling strategy

using only the stock. A simplified version of this valuation technique is thebinomial

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. Most of the model's results are input-dependent (meaning the final price

depends heavily on how we derive the pricing inputs).[21]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).

Criticism

Derivatives are often subject to the following criticisms:

[edit]Hidden Tail RiskAccording toRaghuram Rajan, a former chief economist of theInternational Monetary

Fund(IMF), "... it may well be that the managers of these firms [investment funds] have

figured out the correlations between the various instruments they hold and believe they are

hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the

default on Russian government debt is that correlations that are zero or negative in normal

times can turn overnight to one a phenomenon they term phase lock-in. A hedged

position can become unhedged at the worst times, inflicting substantial losses on those who

mistakenly believe they are protected."[22]
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[edit]Risk

See also:List of trading losses

The use of derivatives can result in large losses because of the use ofleverage, or

borrowing. Derivatives allowinvestorsto earn large returns from small movements in theunderlying 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 the following:

American International Group(AIG) lost more than US$18 billion through a

subsidiary over the preceding three quarters onCredit Default

Swaps(CDS).[23]The US federal government then gave the company US$85

billion in an attempt to stabilize the economy before an imminentstock market

crash. It was reported that the gifting of money,which came to be known as the"Back door bailout" of America's largest trading firms, was necessary because

over the next few quarters the company was likely to lose more money.

Theloss of US$7.2 BillionbySocit Gnralein January 2008 through mis-use

of futures contracts.

The loss of US$6.4 billion in the failed fundAmaranth Advisors, which was long

natural gas in September 2006 when the price plummeted.

The loss of US$4.6 billion in the failed fundLong-Term Capital Managementin

1998. The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994

byMetallgesellschaft AG.[24]

The loss of US$1.2 billion equivalent in equity derivatives in 1995 byBarings

Bank.[25]

UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through

unauthorized trading discovered in September, 2011.[26]

This comes to a staggering $39.5 billion, the majority in the last decade after

theCommodity Futures Modernization Act of 2000was passed.

Counter party risk

Some derivatives (especially swaps) expose investors tocounter party risk, or risk arising

from the other party in a financial transaction. 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.
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[edit]Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use

could result in losses for which the investor would be unable to compensate. The possibility

that this could lead to a chain reaction ensuing in an economic crisis was pointed out by

famed investorWarren BuffettinBerkshire 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)

[edit]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.[citation needed] In the view ofMarriner

S. Eccles, USFederal Reserve Chairmanfrom November, 1934 to February, 1948, too high

a level of debt was one of the primary causes of theGreat Depression. (See Berkshire

Hathaway Annual Report for 2002)

[edit]Government regulation

In the context of a 2010 examination of theICE Trust, an industry self-regulatory body,Gary

Gensler, the chairman of theCommodity Futures Trading Commissionwhich 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]heDepartment of Justiceis looking into

derivatives, too. The departments 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."[27]

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,

theCFTC 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.
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Underwriting refers to the process that a large financial service provider (bank, insurer,

investment house) uses to assess the eligibility of a customer to receive their

products (equity capital, insurance,mortgage, or credit). The name derives from

theLloyd's of Londoninsurance market. Financial bankers, who would accept some

of the risk on a given venture (historically asea voyage with associated risks ofshipwreck) in exchange for apremium, would literally write their names under the risk

information that was written on a Lloyd's slip created for this purpose.[citation

neededSecurities underwriting

Securitiesunderwriting refers to the process by whichinvestment banksraise investment

capital from investors on behalf of corporations and governments that are issuing securities

(bothequityanddebt capital). The services of an underwriter are typically used during

apublic offering.

This is a way of selling a newly issued security, such as stocks or bonds, to investors.Asyndicateof banks (the lead managers) underwrites the transaction, which means they

have taken on the risk of distributing the securities. Should they not be able to find enough

investors, they will have to hold some securities themselves. Underwriters make their

income from the price difference (the "underwriting spread") between the price they pay the

issuer and what they collect from investors or from broker-dealers who buy portions of the

offering.

Risk, exclusivity, and reward

Once the underwriting agreement is struck, the underwriter bears the risk of being unable tosell the underlying securities, and the cost of holding them on its books until such time in the

future that they may be favorably sold.

If the instrument is desirable, the underwriter and the securities issuer may choose to enter

into an exclusivity agreement. In exchange for a higher price paid upfront to the issuer, or

other favorable terms, the issuer may agree to make the underwriter the exclusive agent for

the initial sale of the securities instrument. That is, even though third-party buyers might

approach the issuer directly to buy, the issuer agrees to sell exclusively through the

underwriter.

In summary, the securities issuer gets cash up front, access to the contacts and sales

channels of the underwriter, and is insulated from the market risk of being unable to sell the

securities at a good price. The underwriter gets a nice profit from the markup, plus possibly

an exclusive sales agreement.

Also, if the securities are priced significantly below market price (as is often the custom), the

underwriter also curries favor with powerful end customers by granting them an immediate

profit (seeflipping), perhaps in aquid pro quo. This practice, which is typically justified as the

reward for the underwriter for taking on the market risk, is occasionally criticized as

unethical, such as the allegations thatFrank Quattroneacted improperly in doling outhotIPOstock during thedot com bubble.
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Bank underwriting

Inbanking, underwriting is the detailedcreditanalysis preceding the granting of aloan,

based on credit information furnished by the borrower, such as employment history, salary

andfinancial statements; publicly available information, such as the borrower's credit history,

which is detailed in acredit report; and the lender's evaluation of the borrower's credit needs

and ability to pay. Examples includemortgage underwriting.

Underwriting can also refer to the purchase ofcorporate bonds,commercial paper,

government securities, municipal general-obligation bonds by acommercial bankor dealer

bank for its ownaccountor for resale to investors. Bank underwriting of corporate securities

is carried out through separate holding-company affiliates, calledsecurities affiliatesor

Section 20 affiliates.

Insurance underwriting

Insuranceunderwriters evaluate the risk and exposures of potential clients. They decide how

much coverage the client should receive, how much they should pay for it, or whether even

to accept the risk and insure them. Underwriting involves measuring risk exposure and

determining thepremiumthat needs to be charged to insure that risk. The function of the

underwriter is to protect the company's book of business from risks that they feel will make a

loss and issueinsurance policiesat a premium that is commensurate with the exposure

presented by a risk.

Each insurance company has its own set of underwriting guidelines to help the underwriter

determine whether or not the company should accept the risk. The information used toevaluate the risk of an applicant for insurance will depend on the type of coverage involved.

For example, in underwriting automobile coverage, an individual's driving record is

critical.[citation needed] As part of the underwriting process forlifeorhealth insurance,medical

underwritingmay be used to examine the applicant's health status (other factors may be

considered as well, such as age & occupation). The factors that insurers use to classify risks

should be objective, clearly related to the likely cost of providing coverage, practical to

administer, consistent with applicable law, and designed to protect the long-term viability of

the insurance program.[1]

The underwriters may either decline the risk or may provide a quotation in which thepremiums have beenloadedor in which variousexclusionshave been stipulated, which

restrict the circumstances under which a claim would be paid. Depending on the type of

insurance product (line of business), insurance companies use automated underwriting

systems to encode these rules, and reduce the amount of manual work in processing

quotations and policy issuance. This is especially the case for certain simpler life or personal

lines (auto, homeowners) insurance. Some insurance companies, however, rely on agents to

underwrite for them. This arrangement allows an insurer to operate in a market closer to its

clients without having to established a physical presence. ALloyd's Coverholderis one such

example in which a Lloyd's Syndicate (an insurer who is a member ofLloyd's of London)delegates its underwriting authority to, hence allowing that syndicate to operate in a region
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or country as if it is a local insurer. In Hong Kong, where the largest number of

ApprovedLloyd's Coverholdersare domiciled in Asia Pacific,[2]insurers and their potential

clients seek a closer way for the Lloyd's market to access the emerging insurance market of

Asia Pacific and vice versa.[3]

Other forms of underwriting

[edit]Real estate underwriting

In evaluation of a real estate loan, in addition to assessing the borrower, the property itself is

scrutinized. Underwriters use thedebt service coverage ratioto figure out whether the

property is capable of redeeming its own value or not.

[edit]Forensic underwriting

Forensic underwriting is the "after-the-fact" process used by lenders to determine what went

wrong with a mortgage.[4]

Forensic underwriting refers to a borrower's ability to work out amodification scenario with their current lien holder, not to qualify them for a new loan or a

refinance. This is typically done by an underwriter staffed with a team of people who are

experienced in every aspect of the real estate field.

[edit]Sponsorship underwriting

Main article:Underwriting spot

Underwriting may also refer to financialsponsorshipof a venture, and is also used as a term

withinpublic broadcasting(bothpublic televisionandradio) to describe funding given by a

company or organization for the operations of the service, in exchange for a mention of theirproduct or service within the station's programming.

[edit]Thomson Financial League Tables

Underwriting activity reported inThomson Financial League Tables[5](numbers in $ billion)

(number of issues in parentheses):

Global Debt, Equity & Equity-related

Year Underwriting Activity Source

2008 4,715 (13,542) Q4 2008 report

2007 7,510 (22,256) Q4 2007 report

2006 7,643 (21,818) Q4 2006 report
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2005 6,511 (20,118) Q4 2005 report

2004 5,693 (20,066) Q4 2004 report

2003 5,326 (19,706) Q4 2003 report

2002 4,257 (14,070) Q4 2002 report

2001 4,112 (NA) Q4 2001 report

Documents

derivate intro