Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies,. Interest rates and market indexes. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized.
However, the SEC was specifically prohibited from, among other things, imposing reporting, recordkeeping, or disclosure requirements or other prophylactic measures designed to prevent fraud with respect to such agreements. The Dodd-Frank Act divides regulatory authority over swap agreements between the CFTC and SEC though the prudential regulators, such as the Federal Reserve Board, also have an important role in setting capital and margin for swap entities that are banks.
The CFTC has primary regulatory authority over all other swaps, such as energy and agricultural swaps. Privacy Settings Functional cookies , which are necessary for basic site functionality like keeping you logged in, are always enabled. Financial derivatives are used for two main purposes to speculate and to hedge investments.
Think of it as an insurance policy—farmers purchase derivatives that allow them to benefit if the weather damages or destroys their crop. If the weather is good, and the result is a bumper crop, then the farmer is only out the cost of purchasing the derivative. Part of the reason why many find it hard to understand derivatives is that the term itself refers to a wide variety of financial instruments.
At its most basic, a financial derivative is a contract between two parties that specifies conditions under which payments are made between two parties. Conditions that determine when payments are made often include the price of the underlying asset and the date at which the underlying asset achieves that price.
A call option gives the buyer of the option the right, but not the obligation, to purchase an agreed quantity of stock at a certain price on a certain date. Call options are speculative, risky investments. You can often be right on the direction that the stock price moves, but wrong on timing.
It can be a very painful lesson to learn. Not everyone is a fan of using derivatives, including investors as regarded as Warren Buffett. Buffett has largely been proven correct in the time since his initial statement, now that experts widely blame derivative instruments like collateralized debt obligations CDOs and credit default swaps CDSs for the financial crisis in Derivatives may not be a financial instrument that the average investor wants to try on her own, but derivatives can add value to society when used appropriately and in moderation.
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The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission CFTC and those details are not finalized nor fully implemented as of late However, these are "notional" values, and some economists say that these aggregated values greatly exaggerate the market value and the true credit risk faced by the parties involved. Still, even these scaled-down figures represent huge amounts of money.
At least for one type of derivative, Credit Default Swaps CDS , for which the inherent risk is considered high [ by whom? It was this type of derivative that investment magnate Warren Buffett referred to in his famous speech in which he warned against "financial weapons of mass destruction". Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties.
Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset i. Importantly, either party is therefore exposed to the credit quality of its counterparty and is interested in protecting itself in an event of default. Option products have immediate value at the outset because they provide specified protection intrinsic value over a given time period time value.
One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections intrinsic value and one that extends for a year rather than six months time value.
Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value i.
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to 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 will renege on the contract.
Although a third party, called a clearing 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 has coupon 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.
Derivatives trading of this kind may serve the financial interests of certain particular businesses. The corporation is concerned that the rate of interest may be much higher in six months. 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 a notional amount of money.
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. 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 less. Individuals and institutions may also look for arbitrage opportunities, 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 when Nick Leeson , a trader at Barings Bank , made poor and unauthorized investments in futures contracts. The true proportion of derivatives contracts used for hedging purposes is unknown,  but it appears to be relatively small. In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:.
Over-the-counter OTC derivatives are contracts that are traded and privately negotiated directly between two parties, without going through an exchange or other intermediary. Products such as swaps , forward rate agreements , exotic options — and other exotic derivatives — are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds.
Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements , who first surveyed OTC derivatives in ,  reported that the " gross market value , which represent the cost of replacing all open contracts at the prevailing market prices, Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counterparty risk , like an ordinary contract , since each counter-party relies on the other to perform.
Exchange-traded derivatives ETD are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange.
To maintain these products' net asset value , these funds' administrators must employ more sophisticated financial engineering methods than what's usually required for maintenance of traditional ETFs. These instruments must also be regularly rebalanced and re-indexed each day. An "asset-backed security" is used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities MBS Example: "The capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs".
Like other private-label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is "sliced" into "tranches" , which "catch" the cash flow of interest and principal payments in sequence based on seniority.
The last to lose payment from default are the safest, most senior tranches. Separate special-purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors. CDO collateral became dominated not by loans, but by lower level BBB or A tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages. A credit default swap CDS is a financial swap agreement that the seller of the CDS will compensate the buyer the creditor of the reference loan in the event of a loan default by the debtor or other credit event.
The buyer of the CDS makes a series of payments the CDS "fee" or "spread" to the seller and, in exchange, receives a payoff if the loan defaults. In the event of default the buyer of the CDS receives compensation usually the face value of the loan , and the seller of the CDS takes possession of the defaulted loan. However, anyone with sufficient collateral to trade with a bank or hedge fund can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan these are called "naked" CDSs.
If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction ; the payment received is usually substantially less than the face value of the loan. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. In addition to corporations and governments, the reference entity can include a special-purpose vehicle issuing asset-backed securities. A CDS can be unsecured without collateral and be at higher risk for a default.
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at an amount agreed upon today, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position , and the party agreeing to sell the asset in the future assumes a short position.
The price agreed upon is called the delivery price , which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
The forward price of such a contract is commonly contrasted with the spot price , which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit , or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk typically currency or exchange rate risk , as a means of speculation , or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
A closely related contract is a futures contract ; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. However, being traded over the counter OTC , forward contracts specification can be customized and may include mark-to-market and daily margin calls.
Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain. In finance , a 'futures contract' more colloquially, futures is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today the futures price with delivery and payment occurring at a specified future date, the delivery date , making it a derivative product i.
The contracts are negotiated at a futures exchange , which acts as an intermediary between buyer and seller. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be " long ", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be " short ".
While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange is to act as intermediary and mitigate the risk of default by either party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial amount of cash performance bond , the margin.
Margins, sometimes set as a percentage of the value of the futures contract, need to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically be making or losing money. To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis.
This is sometimes known as the variation margin where the futures exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account. If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account.
This process is known as "marking to market". Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value i. Upon marketing the strike price is often reached and creates much income for the "caller". A closely related contract is a forward contract. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date.
However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange. Unlike an option , both parties of a futures contract must fulfill the contract on the delivery date.
The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date.
The difference in futures prices is then a profit or loss.. A mortgage-backed security MBS is an asset-backed security that is secured by a mortgage , or more commonly a collection "pool" of sometimes hundreds of mortgages. The mortgages are sold to a group of individuals a government agency or investment bank that " securitizes ", or packages, the loans together into a security that can be sold to investors.
The mortgages of an MBS may be residential or commercial , depending on whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac , or they can be "private-label", issued by structures set up by investment banks. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs.
Other types of MBS include collateralized mortgage obligations CMOs, often structured as real estate mortgage investment conduits and collateralized debt obligations CDOs. The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as tranches French for "slices" , each with a different level of priority in the debt repayment stream, giving them different levels of risk and reward.
The total face value of an MBS decreases over time, because like mortgages, and unlike bonds , and most other fixed-income securities, the principal in an MBS is not paid back as a single payment to the bond holder at maturity but rather is paid along with the interest in each periodic payment monthly, quarterly, etc. This decrease in face value is measured by the MBS's "factor", the percentage of the original "face" that remains to be repaid.
In finance , an option is a contract which gives the buyer the owner the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction—that is to sell or buy—if the buyer owner "exercises" the option.
The buyer pays a premium to the seller for this right. An option that conveys to the owner the right to buy something at a certain price is a " call option "; an option that conveys the right of the owner to sell something at a certain price is a " put option ". Both are commonly traded, but for clarity, the call option is more frequently discussed.
Options valuation is a topic of ongoing research in academic and practical finance. In basic terms, the value of an option is commonly decomposed into two parts:. Although options valuation has been studied since the 19th century, the contemporary approach is based on the Black—Scholes model , which was first published in Options contracts have been known for many centuries.
However, both trading activity and academic interest increased when, as from , options were issued with standardized terms and traded through a guaranteed clearing house at the Chicago Board Options Exchange. Today, many options are created in a standardized form and traded through clearing houses on regulated options exchanges , while other over-the-counter options are written as bilateral, customized contracts between a single buyer and seller, one or both of which may be a dealer or market-maker.
Options are part of a larger class of financial instruments known as derivative products or simply derivatives. A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds , the benefits in question can be the periodic interest coupon payments associated with such bonds.
Specifically, two counterparties agree to the exchange one stream of cash flows against another stream. These streams are called the swap's "legs". The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated. Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate , foreign exchange rate , equity price, or commodity price.
The cash flows are calculated over a notional principal amount. Contrary to a future , a forward or an option , the notional amount is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk , or to speculate on changes in the expected direction of underlying prices.
Swaps were first introduced to the public in when IBM and the World Bank entered into a swap agreement. In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative market participant. 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. 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 of financial mathematics.
However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black—Scholes formula , which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock.
A simplified version of this valuation technique is the binomial 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.
Yet as Chan and others point out, the lessons of summer 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". The use of derivatives can result in large losses because of the use of leverage , or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying 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:. Some derivatives especially swaps expose investors to counterparty 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. 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 investor Warren Buffett in Berkshire Hathaway 's annual report. Buffett called them 'financial weapons of mass destruction. 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 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. 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. Indeed, the use of derivatives to conceal credit risk from third parties while protecting derivative counterparties contributed to the financial crisis of in the United States. In the context of a examination of the ICE Trust , an industry self-regulatory body, Gary Gensler , the chairman of the Commodity Futures Trading Commission which 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]he Department of Justice is looking into derivatives, too. The department's 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.
Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies,. Interest rates and market indexes. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized.
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|Investment trading consulting||Apply Now. Counterparty risks derivative investments a kind of credit risk in that the buyer or seller may not be able to live up to the obligations outlined in the contract. The offers that appear in this table are from partnerships from which Investopedia receives compensation. One common form of option product familiar to many consumers is insurance for homes and automobiles. Recommended Stories. Credit Derivative.|
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|Derivative investments||The department's antitrust unit is actively investigating 'the possibility of anticompetitive practices in derivative investments credit derivatives clearing, trading and information services industries', according to a department spokeswoman. Retrieved October 19, Recent Stories. Company-A needed derivative investments in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures 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. Table of Contents Expand. Robert Kelly is involved in developing energy projects utilizing emerging technologies including renewable energy solar, wind and natural gas.|
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Option products e. While a derivative's value is based on an asset, ownership of a derivative doesn't mean ownership of the asset. Futures contracts, forward contracts, options, swaps , and warrants are commonly used derivatives. A futures contract , for example, is a derivative because its value is affected by the performance of the underlying asset. A futures contract is a contract to buy or sell a commodity or security at a predetermined price and at a preset date in the future.
Futures contracts are standardized for by specific quantity sizes and expirations dates. Futures contracts can be used with commodities, such as oil and wheat, and precious metals such as gold and silver. An equity or stock option is a type of derivative because its value is "derived" from that of the underlying stock.
Options come in forms: calls and puts. A call option gives the holder the right to buy the underlying stock at a preset price called the strike price and by a predetermined date outlined in the contract called the expiration date. A put option gives the holder the right to sell the stock at the preset price and date outlined in the contract. There's an upfront cost to an option called the option premium.
The risk-reward equation is often thought to be the basis for investment philosophy and derivatives can be used to either mitigate risk hedging , or they can be used for speculation where the level of risk versus reward would be considered. Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the contract.
Some derivatives are traded on national securities exchanges and are regulated by the U. Other derivatives are traded over-the-counter OTC , which involve individually negotiated agreements between parties. Most derivatives are traded on exchanges. The CFTC regulates the futures markets and is a federal agency that is charged with regulating the markets so that the markets function in a fair manner.
The oversight can include preventing fraud, abusive trading practices, and regulating brokerage firms. The members of these exchanges are regulated by the SEC, which monitors the markets to ensure they are functioning properly and fairly.
It's important to note that regulations can vary somewhat, depending on the product and its exchange. In the currency market, for example, the trades are done via over-the-counter OTC , which is between brokers and banks versus a formal exchange. Two parties, such as a corporation and a bank, might agree to exchange a currency for another at a specific rate in the future.
Banks and brokers are regulated by the SEC. However, investors need to be aware of the risks with OTC markets since the transactions do not have a central marketplace nor the same level of regulatory oversight than those transaction done via a national exchange.
A commodity futures contract is a contract to buy or sell a predetermined amount of a commodity at a preset price on a date in the future. Commodity futures are often used to hedge or protect investors and businesses from adverse movements in the price of the commodity. For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance.
Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer is assured of a specified price for the commodity, prices could rise due to, for instance, a shortage because of weather-related events and the farmer will end up losing any additional income that could have been earned.
Likewise, prices for the commodity could drop, and the miller will have to pay more for the commodity than he otherwise would have. Let's use the story of a fictional farm to explore the mechanics of several varieties of derivatives. Gail, the owner of Healthy Hen Farms, is worried about the recent fluctuations in chicken prices or volatility within the chicken market due to reports of bird flu. Gail wants to protect her business against another spell of bad news. So she meets with an investor who enters into a futures contract with her.
By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations. It's important to remember that when companies hedge, they're not speculating on the price of the commodity. Instead, the hedge is merely a way for each party to manage risk. Each party has their profit or margin built into their price, and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity.
Whether the price of the commodity moves higher or lower than the futures contract price by expiry, both parties hedged their profits on the transaction by entering into the contract with each other. Derivatives can also be used with interest-rate products. Interest rate derivatives are most often used to hedge against interest rate risk. Loans, for example, can be issued as fixed-rate loans, same interest rate through the life of the loan , while others might be issued as variable-rate loans, meaning the rate fluctuates based on interest rates in the market.
Some companies might want their loans switched from a variable rate to a fixed rate. For example, if a company has a really low rate, they might want to lock it in to protect them in case rates rise in the future. Other companies might have debt with a high fixed-rate versus the current market and want to switch or swap that fixed-rate for the current, lower variable rate in the market.
The exchange can be done via an interest-rate swap in which the two parties exchange their payments so that one party receives the floating rate and the other party the fixed rate. Continuing our example of Healthy Hen Farms, let's say that Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and wants to open her own processing plant.
She tries to get more financing, but the lender , Lenny, rejects her. Lenny's reason for denying financing is that Gail financed her takeovers of the other farms through a massive variable-rate loan, and Lenny is worried that if interest rates rise, she won't be able to pay her debts. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase, too.
Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail's, and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future. For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans. They work out a deal in which Gail's payments go toward Sam's loan, and his payments go toward Gail's loan.
Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want. The transaction is a bit risky for both of them because if one of them defaults or goes bankrupt , the other will be snapped back into their old loan, which may require payment for which either Gail of Sam may be unprepared.
However, it allows them to modify their loans to meet their individual needs. A credit derivative is a contract between two parties and allows a creditor or lender to transfer the risk of default to a third party. The contract transfers the credit risk that the borrower might not pay back the loan. There are two major types. The most common type of derivative is a swap. It is an agreement to exchange one asset or debt for a similar one. The purpose is to lower risk for both parties.
These are OTC, so these are 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. They also helped cause the financial crisis. They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. The two parties can customize their forward a lot. 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.
Derivatives have four large risks. The most dangerous is that it's almost impossible to know any derivative's real value. It's based on the value of one or more underlying assets. Their complexity makes them difficult to price. No one, not even the computer programmers who created them, knew what their price was when housing prices dropped.
Banks had become unwilling to trade them because they couldn't value them. If the commodity price keeps dropping, covering the margin account can lead to enormous losses. The third risk is their time restriction. It's one thing to bet that gas prices will go up. It's another thing entirely to try to predict exactly when that will happen. No one who bought MBS thought housing prices would drop.
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. Last but not least is the potential for scams. Fraud is rampant in the derivatives market. Accessed June 24, World Federation of Exchanges.
Bank for International Settlements. The Stationery Office, Barclay Hedge. CME Group. Intercontinental Exchange. Institute for Research on Labor and Employment. Routledge, United States Government Accountability Office. Corporate Finance Institute. Brookings Institution.
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