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Derivative security

 

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In finance, a derivative security or derivative is a contract which specifies the right or obligation between two parties to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event.

Another way of defining a derivative is that it is a security whose value is determined (derived) from one or more other securities, commodities, or events. The value is influenced by the features of the derivative contract, including the timing of the contract fulfillment, the value of the underlying security or commodity, and other factors like volatility.

The payments between the parties may be determined by the future changes of:

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

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

Common examples of derivatives are

  • stock options,
  • interest rate swaps
  • futures
  • foreign exchange forwards or options
  • credit default swaps

Some less common, but economically intriguing examples are:

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

Derivatives are one of the most rapidly growing and changing areas of modern finance. According to the BIS, as of December 2002 "total estimated notional amount of outstanding OTC contracts stood at $141.7 trillion."

The most common use of derivative securities is as a tool to buy and sell risk. For example, a farmer may seek to sell a future in a commodity such as wheat at a fixed price to a speculator. The farmer reduces his risk that the price of wheat will unexpectedly raise or fall, and the speculator assumes this risk with the possibility of a large reward.

Because derivative securities offers 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.

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 with a derivative security, someone loses money while someone else gains money, under normal circumstances trading in derivatives should not adversely affect the economic system. There is a danger, that someone would lose so much money that they would be unable to pay for their losses. There is a danger that this would cause a chain reactions would would create an economic crisis. In 2002 legendary investor Warren Buffett in an interview with the New York Times commented that he had accumlated his wealth without the use of derivatives and that he regarded them as 'financial weapons of mass destruction', an allusion to the phrase 'weapons of mass destruction' relating to physical weapons which had wide currency at the time. Although there have been instances of massive losses, most notably by Long Term Capital Management these have not have reprecussive effects. In fact Federal Reserve Board chairman Alan Greenspan commmented in 2003 that he believed that the use of the use of derivatives have softened the impact of the economic downturn at beginning of the twenty-first century.

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

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