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TYPES OF DERIVATIVES OTC and exchange-traded Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:
Common contract types There are three major classes of derivatives:
Examples Some common examples of these derivatives are: Some less common examples of underlyings are:
CASH FLOW The payments between the parties may be determined by:
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. VALUATION Market price and fair value Two common measures of value are:
Determining the market price For exchange traded derivatives, market price is usually transparent (often published in real-time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices. Determining fair value The fair value of a derivatives contract is often complex, partly because of the immense variation in the contracts, and partly because there are often many different variables to consider. Fair valuation of derivatives is a central topic of Financial Mathematics . Where "fair" refers to the absence of Arbitrage , meaning that no riskless profits can be made by trading in assets. Crucial to the valuation of derivatives is also the Stochastic s of the underlying assets, typically expressed as a Stochastic Process . A key equation for the theoretical Valuation Of Options 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. Other derived equations include the Binomial Options Model , Kim and Garman-Kohlhagen models. USAGES Insurance and hedging One use of derivatives is as a tool to transfer Risk . For example, farmers can sell Futures Contract s 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. It is not unknown for farmers to walk away smiling, when they have lost out in the derivatives market, as the result of a hedge. In this case, they have profited from the real market from the sale of their crops. Contrary to popular belief, financial markets are not always a Zero-sum game. This is an example of a situation where both parties in a financial markets transaction benefit. Another example is the company and Accounts Payable planning. On 2005-06-05 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003 ( Revised 2004 10K (PDF, 787 KB) ). Speculation and arbitrage 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. In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the Volatility of the underlying security. This technique is commonly used when speculating with traded options. 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. Pricing and information sharing Futures markets are unusually efficient at gathering and processing information, and are often an extremely accurate predictor of events such as interest rate movements and oil price movements. DARPA also examined the idea of developing a futures market for world events, the Policy Analysis Market , with the idea of predicting terrorism amongst other things. The idea was halted due to political uproar, as it was pointed out that terrorists could trade on the market and directly profit from their activities. CONTROVERSY Besides the Nick Leeson affair, there have been several instances of massive losses in derivative markets. These events include the largest municipal bankruptcy in U.S. history, Orange County, CA in 1994, and the Bankruptcy of Long-Term Capital Management . On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Because derivatives offer the possibility of large rewards, many individuals have the strong desire to invest in derivatives. Most financial planners caution against this, pointing out that an investor in derivatives often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor ( {Link without Title} ). 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. Economist s 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, under normal circumstances, trading in derivatives should not adversely affect the economic system. 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. Former 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. GLOSSARY ''From: Quarterly Derivatives Fact Sheet ''
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