Derivative (finance)

src: i.ytimg.com

In finance, derivatives are contracts that earn the value of the performance of the underlying entity. This underlying entity may be an asset, an index, or an interest rate, and is often simply called "underlying". Derivatives can be used for a number of purposes, including insuring against hedging, increasing exposure to price movements for speculation or gaining access to tricky assets or markets. Some of the more common derivatives include forward, futures, options, swaps, and variations of these such as syndicated debt obligations and credit default swaps. Most derivatives are traded over-the-counter (on-exchange) or on the exchange such as the New York Stock Exchange, while most insurance contracts have developed into separate industries. In the United States, following the financial crisis of 2007-2009, there is increasing pressure to move derivatives into trade on the exchange. Derivatives are one of the three main categories of financial instruments, the other two are shares (ie, stocks or shares) and debt (ie, bonds and mortgages). The oldest example of a descend in history is considered an olive contract transaction, entered by the ancient Greek philosopher Thales, and proved by Aristotle, who made a profit in exchange. The bucket shops, banned a century ago, are a more recent example of history.

Video Derivative (finance)

Basics

Derivatives are contracts between two parties that specify conditions (especially dates, generate values ​​and definitions of the underlying variable, contractual obligations of the parties, and notional amounts) in which payments must be made between the parties. Assets include commodities, stocks, bonds, interest rates, and currencies, but they can also be other derivatives, which add another layer of complexity to the right judgment. The components of the company's capital structure, for example, bonds and stocks, can also be considered as derivatives, a more appropriate option, with the underlying asset of the company, but this is unusual outside the technical context.

From an economic point of view, financial derivatives are cash flows, which are stochastic conditioned and discounted to present value. Market risks attached to the underlying asset are attached to financial derivatives through contractual agreements and can therefore be traded separately. The underlying asset should not be obtained. Therefore, derivatives allow separation of ownership and participation in the market value of an asset. It also provides a large amount of freedom related to contract design. The contractual freedom allows a derivative designer to modify participation in underlying arbitrary asset performance. Thus, participation in underlying market value can be effectively weaker, stronger (leverage effect), or implemented in reverse. Therefore, in particular the market price risk of the underlying asset can be controlled in almost every situation.

There are two groups of derivative contracts: privately traded over-the-counter (OTC) derivatives such as non-exchange swaps or other intermediaries, and exchange-traded derivatives (ETDs) traded through the exchange of special derivatives or other exchanges.

Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the 18th century. Derivatives are broadly categorized by relationships between basic assets and derivatives (such as forward, options, swaps); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the markets in which they trade (such as exchange or over-the-counter); and their pay-off profiles.

Derivatives can be broadly categorized as "key" or "option" products. Product key (such as swap, futures, or forward) requires contracting parties to comply with contract terms. Preferred products (such as interest rate swaps) entitle the buyer, but not the obligation to enter into a contract in accordance with specified conditions.

Derivatives can be used either for risk management (ie to "hedge" by compensating compensation in the event of an undesirable event, a kind of "insurance") or for speculation (ie making a "financial bet"). This distinction is important because the former is a prudent aspect of operations and financial management for many companies in many industries; the latter offering risk managers and investors the opportunity to increase profits, which may not be well-expressed to stakeholders.

Together with many other financial products and services, derivative reform is an element of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This law delegates many details of regulatory oversight rules to the Commodity Futures Trading Commission (CFTC) and details -the details are not completed or fully implemented by the end of 2012.

Maps Derivative (finance)

Market size

To provide an overview of the size of the derivative market, The Economist has reported that in June 2011, the over-the-counter (OTC) derivative market totaled about $ 700 trillion, and the market size of exchange traded at an additional $ 83 trillion. However, this is a "notional" value, and some economists say that this value greatly exaggerates the market value and credit risks that are actually encountered by the parties involved. For example, in 2010, while aggregate OTC derivatives exceeded $ 600 trillion, market value is expected to be much lower, at $ 21 trillion. Credit risk equivalent to derivative contracts is estimated at $ 3.3 trillion.

However, these scaled numbers represent large sums of money. For perspective, the budget for total US government spending for 2012 is $ 3.5 trillion, and the current total value of the US stock market is estimated at $ 23 trillion. The world's annual Gross Domestic Product is about $ 65 trillion.

And for one type of derivative at least, Credit Default Swaps (CDS), whose inherent risk is considered high, the higher, the nominal value, remains relevant. This type of derivative is what Warren Buffett invested in his famous 2002 speech in which he warned against "weapons of mass destruction". CDS notional value in early 2012 reached $ 25.5 trillion, down from $ 55 trillion in 2008.

src: i.ytimg.com

Usage

Derivatives are used for the following:

• Hedging or to reduce the underlying risk, by entering into a derivative contract whose value moves in the opposite direction to its base position and canceling some or all of it out
• Create an option capability where the derivative value is associated with a particular condition or event (for example, the underlying reaches a certain price level)
• Get exposure to the underlying things where it's not possible to traffic the underlying (for example, weather derivatives)
• Influence (or equivalence), so small movements in the underlying value can cause a big difference in the derivative value
• Speculate and generate profits if the underlying asset values ​​move as they expect (eg move in a certain direction, stay in or out of a specified range, reach a certain level)
• Transfer asset allocations between different asset classes without disrupting the underlying asset, as part of transition management
• Avoid paying taxes. For example, an equity swap allows an investor to receive a fixed payout, e.g. based on LIBOR levels, while avoiding paying capital gains taxes and stock keeping.

Mechanics and ratings

The product key is theoretically zero at the time of execution and thus usually does not require a face-to-face exchange between the parties. Based on the underlying asset movement over time, however, the value of the contract will fluctuate, and the derivative may be an asset (ie, "in money") or a liability (ie "out of money") at various points throughout its life. Importantly, one party is therefore exposed to the credit quality of his counterparts and is interested in protecting himself in the event of default.

Option products have immediate value at the beginning because they provide a prescribed protection (intrinsic value) over a specified time period (time value). One common form of choice products that are familiar to many consumers are insurance for homes and cars. The insured will pay more for a policy with greater responsibility protection (intrinsic value) and which is extended for one year instead of six months (time value). Due to the value of the direct option, the buyer of the option usually pays a premium in advance. Just as for a key product, the movement in the underlying asset will cause the intrinsic value of the option to change over time while the time value deteriorates steadily until the contract expires. An important distinction between key products is that, after the initial exchange, the buyer of the option has no further responsibility to the counterparty; at maturity, the buyer will execute an option if it has a positive value (that is, if it is "in money") or ends at no cost (other than the initial premium) (that is, if the option is "out of money").

Hedging

Derivatives allow the risk associated with the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a mill can sign a futures contract to exchange a certain amount of cash for a certain amount of wheat in the future. Both sides have reduced future risks: for wheat farmers, price uncertainty, and for factories, the availability of wheat. However, there is still a risk that no wheat will be available due to events not determined by the contract, such as the weather, or that either party will renege on the contract. Although a third party, called a clearinghouse, guarantees futures contracts, not all derivatives are insured against the opponent's risk.

From another perspective, farmers and mills both reduce risks and risk when they sign a futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and risk that the price of wheat will rise above the price specified in the contract ( thereby losing the additional revenue that he could get). The plant, on the other hand, is at risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than it should be) and reduce the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is an insurer (risk taker) for one type of risk, and the other is the risk taker for another type of risk.

Hedging also occurs when a person or institution buys assets (such as commodities, bonds that have coupon payments, shares paying dividends, etc.) and sells them on futures. Individuals or institutions have access to assets for a certain period of time, and then can sell them in the future at a price determined in accordance with futures contracts. Of course, this allows individuals or institutions to profit from holding assets, while reducing the risk that future selling prices will deviate unexpectedly from the current market assessment of the future value of assets.

Such derivative trading can serve the financial interests of certain particular businesses. For example, companies borrow large sums of money at certain interest rates. The interest rate on the loan every six months. Corporations are worried that interest rates may be much higher in six months. Corporations may purchase a forward rate agreement (FRA), which is a contract to pay a fixed rate interest rate six months after the purchase with the notional amount of money. If the interest rate after six months is above the contract level, the seller will pay the difference to the company, or the TRD buyer. If the rate is lower, the company will pay the difference to the seller. The FRA purchase serves to reduce uncertainty about tariff increases and stabilize revenue.

Speculation and arbitration

Derivatives can be used to take risks, not to protect against risks. Thus, some individuals and institutions will enter into derivative contracts to speculate on the value of the underlying asset, betting that the insurer will be wrong about the future value of the underlying asset. Speculators look to buy future assets at low prices in accordance with derivative contracts when future market prices are high, or to sell future assets at high prices in accordance with derivative contracts when future market prices are less.

Individuals and institutions may also seek arbitrage opportunities, such as when the current purchase price of an asset falls below the price specified in the futures contract to sell the asset.

Speculative trading in derivatives gained much notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made a bad and invalid investment in futures contracts. Through a combination of poor judgment, lack of supervision by bank management and regulators, and unfavorable events like the Kobe earthquake, Leeson suffered a $ 1.3 billion loss that broke the institution for centuries.

Proportion is used for hedging and speculation

The actual proportion of the derivative contracts used for hedging purposes is unknown, but seems relatively small. Also, derivative contract accounts for only 3-6% of the total currency and interest rate exposure of the median firm. Nonetheless, we know that many of the company's derivative activities have at least some speculative components for various reasons.

src: i.ytimg.com

Type

OTC and swap

In general, there are two groups of derivative contracts, which are differentiated by the way they trade on the market:

• Over-the-counter (OTC) Derivatives are individually traded (and negotiated privately) contracts between two parties, without exchange or other intermediaries. Products like swaps, advanced pricing 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 largely unregulated in relation to disclosure of information between the parties, as the OTC market consists of banks and other highly sophisticated parties, such as hedge funds. Reporting the number of OTCs is difficult because trades can happen personally, without any activity seen in any exchange.

According to the Bank for International Settlements, which first surveyed derivative OTCs in 1995, reported that "gross market value, representing the cost of replacing all open contracts at prevailing market prices,... increased by 74% from 2004 to $ 11 trillion at the end of June 2007 (BIS 2007: 24). "The position on the OTC derivatives market increased to $ 516 trillion at the end of June 2007, 135% higher than the recorded rate in 2004. The total notional amount outstanding is US $ 708 trillion (as of June 2011). Of this notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are. Since OTC derivatives are not traded on the exchange, there is no central counter-party. Therefore, they are subject to the risk of counterparty, such as ordinary contracts, because each counter-party relies on the other to perform.

• Exchange-traded derivatives (ETD) are derivative instruments traded through the exchange of special derivatives or other exchanges. Derivative exchange is a market in which individuals trade standardized contracts that have been determined by the exchange. The derivative exchange acts as an intermediary for all related transactions, and takes the initial margin of both sides of the trade to act as collateral. The world's largest exchange of derivatives (with number of transactions) is Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists various European products such as interest rates & index products), and CME Group (consisting of 2007 mergers from Chicago Mercantile Exchange and Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivative exchanges totaled USD 344 trillion during Q4 2005. In December 2007, the Bank for International Settlements reported that "exchange-traded derivatives jumped 27% to a record $ 681 trillion."

Generic derivative contract

Some common variants of derivative contracts are as follows:

1. Forward: An adjusted contract between two parties, where the payment is made at a specified time in the future at a predetermined price.
2. Futures: is a contract to buy or sell an asset on a future date at a price determined today. Futures contracts differ from forward contracts because futures contracts are standard contracts written by the clearing house operating the exchange in which the contract may be bought and sold; forward contracts are non-standard contracts written by the parties themselves.
3. Choice is a contract that gives the owner the right, but not the obligation, to buy (in the case of call options) or sell (in the case of put options) assets. The price at which the sale takes place is known as the strike price, and is determined when the parties enter the option. The option contract also specifies the due date. In the case of the European option, the owner has the right to require that the sale be made on (but not before) the due date; in the case of the American option, the owner may request that the sale be made at any time until the due date. If the contract owner exercises this right, the other party has an obligation to make a transaction. The options are of two types: call options and put options. The calling option buyer has the right to purchase a certain amount of the underlying asset, at a price specified on or before a specified future date, but it has no obligation to exercise this right. Similarly, the put option buyer has the right to sell a certain quantity of the underlying asset, at a price specified on or before a specified future date, but he has no obligation to exercise this right.
4. Binary options are contracts that give the owner an all-or-nothing profit profile.
5. Warrants: Regardless of the commonly used short-term option that has a maximum maturity period of one year, there are certain long-term options known as warrants. These are usually traded on the table.
6. Swap is a contract to exchange cash (current) on or before a certain future date based on the underlying value of exchange rate, bonds/interest rate, commodity exchange, stock or other assets. Another term commonly associated with swap is swaption , the term for what is essentially an option on the forward exchange. Similar to call and put options, swaptions are of two kinds: receiver and payer . In the case of a recipient's swaption there is an option whereby one can receive fixed and floating payments; in the case of a payer exchange, one has the option of paying fixed and receiving floats.

Swap basically can be categorized into two types:

• Interest rate swap: This essentially requires to exchange only the related interest cash flows in the same currency, between two parties.
• Currency swap: In this kind of exchange, cash flow between the two parties includes principal and interest. Also, the money being exchanged is a different currency for both parties.

Some common examples of these derivatives are as follows:

Debt obligations payable

A guaranteed debt obligation ( CDO ) is a type of security supported by structured assets (ABS). An "asset-backed security" is used as a general term for the type of security supported by a pool of assets - including bonds and mortgage-backed securities (Example: "The capital markets in which the asset-backed securities are published and traded are made up of three main categories: ABS, MBS and CDO "(source: Vink, Dennis." ABS, MBS and CDO were compared: Empirical analysis " (PDF) . August 2007. Munich Personal RePEc Archive . Retrieved July 13 2013 . Ã, )
- and sometimes for certain types of security - supported by consumer loans (eg: "As a rule of thumb, the securitization issues supported by mortgages are called MBS, and securitization issues supported by debt obligations are called CDOs, [and] Problems securitization supported by consumer-supported products - car loans, consumer loans and credit cards, among others - are called ABS.Vink, Dennis, "ABS, MBS and CDO sources are compared: Empirical Analysis" < span> (PDF) . August 2007 .My Personal RePEc Archive . Retrieved July 13 2013 . ,
see also "What is Asset Backed Securities?". SIFMA . Retrieved July 13 2013 . The asset-backed securities, called ABS, are bonds or debt securities backed by financial assets. Typically, these assets consist of accounts receivable other than a mortgage loan, such as credit card bills, car loans, artificial housing contracts and home equity loans. ) & lt;/ref & gt; Originally developed for corporate debt markets, CDOs have long evolved to include mortgage and mortgage-backed security (MBS) markets. Like other private-label securities supported by assets, CDOs can be considered as a promise to pay investors in the order specified, based on the cash flows collected by CDOs from the collection of bonds or other assets they own. CDO "sliced" into "tranche", which "captures" cash flows and principal payments on a seniority basis. If some of the bad loans and cash collected by the CDO are not sufficient to pay all investors, those at the lowest, most "junior" tranches suffer losses first. The latter loses payment from default is the safest, most senior tranches. As a result, coupon payments (and interest rates) vary by tranche with the safest/most senior part paying the lowest and lowest parts paying the highest rate to compensate for a higher default risk. For example, a CDO may issue the following phases in order of security: Senior AAA (sometimes known as "super senior"); Junior AAA; A A; A; BBB; Rest.

Separating special purpose entities - rather than the parent investment bank - issuing CDOs and paying interest to investors. When the CDO is developed, some sponsors repackage the tranche into another iteration called "CDO-Squared" or "CDO CDO". In early 2000, CDOs were generally diversified, but in 2006-2007 - when the CDO market grew to hundreds of billions of dollars - this changed. CDO collateral becomes dominated not by loans, but by a lower rate (BBB or A) tranche recycled from other asset-backed securities, whose assets are usually non-prime mortgages. The CDO has been called "the engine that drives the mortgage supply chain" for nonprime mortgages, and is credited with providing larger incentive lenders to make non-prime loans leading to the 2007-9 subprime mortgage crisis.

Change default credit

A credit default swap ( CDS ) is a financial swap agreement that sellers of CDS will compensate buyers (reference creditors) in terms of default loans (by debtors) or other credit events. The CDS buyer makes a set of payment (CDS "fee" or "spread") to the seller and, in exchange, receives a payment if the credit is stuck. It was created by Blythe Masters of JP Morgan in 1994. In the case of default the buyer of the CDS receives compensation (usually the nominal value of the loan), and the seller of the CDS takes ownership of the defaulted loan. However, anyone who has sufficient collateral to trade with a bank or hedge fund can buy CDS, even buyers who do not hold loan instruments and who have no interest that can be insured directly in the loan (this is called CDS "naked"). If there are more outstanding CDS contracts than existing bonds, there is a protocol for holding a credit event auction; the payment received is usually much less than the nominal value of the loan. Credit default swaps have been in existence since the early 1990s, and increased in use after 2003. By the end of 2007, the remarkable number of CDS was $ 62.2 trillion, dropping to $ 26.3 trillion by mid-2010 but reportedly $ 25 , 5 trillion at the beginning of 2012 CDS is not traded on the exchange and no reporting of necessary transactions to government agencies. During the 2007-2010 financial crisis the lack of transparency in this large market became a concern for regulators as it may pose a systemic risk.

In March 2010, the Trade Information Warehouse [DTCC] (see Market Data Sources) announced it would give regulators greater access to its credit default swap database. CDS data can be used by financial professionals, regulators, and media to monitor how the market perceives credit risk from every entity on which CDS is available, comparable to that provided by credit rating agencies. The US court will soon follow suit. Most CDSs are documented using a standard form compiled by the International Swap and Derivatives Association (ISDA), although there are many variants. In addition to basic swaps, single names, there are default swap bins (BDSs), CDS indexes, funded CDS (also called credit-linked notes), as well as credit-only swaps (LCDS) default credit. In addition to companies and governments, reference entities may include special purpose vehicles that issue asset-backed securities. Some claim that derivatives such as CDS are potentially dangerous because they combine priorities in bankruptcy with a lack of transparency. CDS can be unsecured (no collateral) and at higher risk for default.

Forward

In finance, forward contract or just forward is a non-standard contract between two parties to buy or sell the asset at a future time set at the price agreed today, derivative instruments. This is in contrast to a spot contract, which is an agreement to buy or sell an asset on a place date, which may vary depending on the instrument, for example most FX contracts have Spot Dates two business days from today. The party agrees to buy future asset underlying assumes long positions, and the parties agree to sell the asset in the future assumes a short position. The agreed price is called the shipping price, which is the same as the forward price at the time the contract is put in. The price of the underlying instrument, in whatever form, is paid before controlling the instrument changes. This is one of the many forms of buy order/sell in which time and date of trading is not the same as the date on which the securities themselves are exchanged.

The advanced price of such a contract generally contrasts with the spot price, which is the price at which the asset changes hands on the spot date. The difference between a spot and a forward price is a forward or forward discount, generally considered in the form of profit, or loss, by the buyer. In the future, such as other derivative securities, can be used to protect risks (usually currency or exchange risk), as a means of speculation, or to enable parties to take advantage of the quality of time-sensitive underlying instruments.

The closely related contracts are futures contracts; they differ in certain things. The forward contracts are very similar to futures contracts, unless they are not traded on the exchange, or defined on standard assets. In the future it also usually does not have a temporary partial settlement or "true-up" in margin requirements such as futures - in such a way that the parties do not exchange additional properties that secure the party on profit and all unrealized gains or losses increase when the contract is opened. However, with over-the-counter trades (OTC), forward contract specifications can be customized and may include a mark-to-market and daily margin call. Therefore, future contractual arrangements may require the losers to pledge collateral or additional security to better secure the beneficiaries. In other words, the terms of the forward contract will determine the guarantee call based on certain "trigger" events relevant to a particular counterparty such as, among other things, credit ratings, asset values ​​under management or redemption for a specified period of time (eg, quarterly, annually).

Futures

In the field of finance, 'futures' (more colloquial, futures ) is a standard contract between two parties to buy or sell certain assets of standard quantity and quality at a price agreed today ( > futures price ) with deliveries and payments occurring on a predetermined future date, delivery date , making it a derivative product (ie a financial product derived from the underlying asset). Contracts are negotiated on the futures exchange, which acts as an intermediary between the buyer and the seller. Parties that agree to buy the underlying asset in the future, "buyer" of the contract, is said to be "long", and the party that agreed to sell the assets in the future, "seller" contract, said to be "short".

While futures contracts determine future trades, the purpose of a futures exchange is to act as an intermediary and reduce the risk of default by either party in the intervening period. For this reason, futures markets require both parties to install an initial amount of cash (performance bonds), margin. Margin, sometimes set as a percentage of the value of futures contracts, should be maintained proportionately at any time during the contract period to support this mitigation because the contract price will vary according to inventory and demand and will change daily and thus one party or another theoretical will generate or lose money. In order to mitigate the risk and possibility of default by either party, the product is marked for sale on a daily basis where the difference between the agreed price and the daily daily daily price is set daily. This is sometimes known as the margin variation in which the futures exchange will draw money from the losing party margin account and put it to the other party to ensure that the correct daily loss or profit is reflected in their respective accounts. If the margin account is below a certain value set by Exchange, then margin call is made and the account owner must refill the margin account. This process is known as "marking to market". Thus on the date of delivery, the amount exchanged is not the price specified on the contract but the spot value (ie, the original value agreed upon, since any gain or loss has previously been settled by marking to the market). After marketing, strike prices are often achieved and generate a lot of revenue for "callers".

A closely related contract is a forward contract. Progress is like futures in determining exchange rates for a certain price on a certain date in the future. However, forward is not traded on the exchange and thus has no temporary partial payments as it marks to the market. There is also no standard contract, as in the stock exchange. Unlike options, both parties of the futures contract must fulfill the contract on the date of delivery. The seller delivers the underlying asset to the buyer, or, if it is a completed cash futures contract, then cash is transferred from a futures trader who suffers a loss to the person making the profit. To exit the commitments prior to the settlement date, holders of futures positions may close their contractual obligations by taking the opposite position on other futures contracts on the same asset and settlement date. The difference in futures price is profit or loss..

mortgage-backed securities

A mortgage-backed security ( MBS ) is a security-backed asset that is secured by a mortgage, or more generally a collection ("pool") sometimes hundreds of mortgages. Mortgages are sold to a group of individuals (a government body or investment bank) that "secures", or packages, mutual loans into security that can be sold to investors. The mortgage of an MBS may be either residential or commercial, depending on whether it is an MBS Agent or Non-Agency MBS; in the United States they may be issued by structures formed by government-sponsored companies such as Fannie Mae or Freddie Mac, or they can be "private labels", issued by structures formed by investment banks. The MBS structure can be known as a "pass-through", in which interest and principal payments from the borrower or home buyer pass through it to the MBS holders, or perhaps more complicated, consist of other MBS collections. Other types of MBS include debt guarantees (CMOs, often structured as real estate mortgage investment channels) and secured debt bonds (CDOs).

MBS subprime shares issued by various structures, such as CMO, are not identical but rather issued as tranche (French for "slices"), each with different priority levels in debt repayment flows, giving them different levels of risk and rewards. Tranche - especially lower priority, higher interest rates - of MBS are/are often more repackaged and resold as a guaranteed debt obligation. The subprime MBS issued by the investment bank is a major problem in the subprime mortgage crisis of 2006-2008. The total nominal value of MBS declines over time, because like a mortgage, and unlike bonds, and most other fixed income securities, the principal in MBS is not paid back as a single payment to the bondholders at maturity but is paid with interest in each payment periodic (monthly, quarterly, etc.). This decrease in face value is measured by the MBS "factor", the percentage of the original "face" that remains to be repaid.

Options

In finance, the option is a contract that gives the buyer (owner) the right, but not the obligation, to buy or sell the underlying asset or instrument on a given strike price on or before specific date. The seller has a corresponding obligation to fulfill the transaction - ie sell or buy - if the buyer (owner) "performs" option. Buyer pays a premium to the seller for this right. Options that convey to the right owner to buy something for a certain price are "call options"; option that conveys the right of the owner to sell something for a certain price is a "put option". Both are generally traded, but for clarity, call options are more often discussed. Option assessment is an ongoing research topic in academic and practical finance. In basic terms, option values ​​are usually broken down into two parts:

• The first part is the "intrinsic value", which is defined as the difference between the underlying market value and the reprimand price of the given option.
• The second part is the "time value", which depends on a set of other factors that, through multicabel and non-linear reciprocity, reflect the expected value of the discontinuity of the difference in expiration.

Although an optional assessment has been studied since the 19th century, the contemporary approach is based on the Black-Scholes model, first published in 1973.

The option contract has been known for centuries. However, both trading activity and academic interest increased when, since 1973, options were issued with standard terms and traded through clearing guaranteed at the Chicago Board Options Exchange. At present, many options are made in standard form and traded through home clearing in regulated option exchanges, while other over-the-counter options are written as bilateral contracts, tailored between single buyers and sellers, one or both of which may be dealers or manufacturers market. Options are part of a larger class of financial instruments known as derivative products or derivatives only.

Swap

A swap is a derivative in which two counterparty exchange cash flows from a one-party financial instrument to another party's financial instruments. The benefits in question depend on the type of financial instrument involved. For example, in the case of an exchange involving two bonds, the intended benefit may be a periodic interest payment (coupon) associated with the bond. In particular, two counterparties agree with the exchange of one stream of cash flow to another. These streams are called "feet" of swaps. The swap agreement determines the date when the cash flows have to be paid and the way they are charged and calculated. Usually when the contract starts, at least one of a series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.

Cash flows are calculated to exceed the notional principal amount. Contrary to the future, forward or option, the notional amount is usually not exchanged between the opponents. As a result, swap may be in the form of cash or collateral. Swaps can be used to protect certain risks such as interest rate risk, or to speculate about changes in the expected direction of the underlying price.

Swaps were first introduced to the public in 1981 when IBM and the World Bank signed swap agreements. Today, swap is one of the most heavily traded financial contracts in the world: total outstanding interest rates and currency swaps of more than $ 348 trillion in 2010, according to the Bank for International Settlements (BIS). Five common types of swaps, in order of quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps (there are many other types).

src: iaonline.theiia.org

Economic function of the derivative market

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

1. Prices in a structured derivative market not only imitate marketers' acumen about the future but also lead the price that underlies the prevailing future level. At the end of the derivative contract, the derivative price converges with the underlying price. Therefore, derivatives are an important tool for determining current and future prices.
2. The derivatives market reallocates the risks of those who prefer risk aversion to people with risk appetites.
3. The intrinsic nature of the derivative market links it to the underlying spot market. Due to derivatives, there is a considerable increase in the underlying spot market trading volume. The dominant factor behind the escalation is increased participation by additional players who will not participate because there is no procedure to transfer the risk.
4. As surveillance, surveillance of various participants' activities is very difficult in many markets; the formation of an organized marketplace is becoming increasingly important. Therefore, in the presence of an organized derivative market, speculation can be controlled, resulting in a more rigorous environment.
5. Third parties may use publicly available derivative prices as educated predictions about future uncertain outcomes, for example, the likelihood that the company will default on its debt.

In short, there is a substantial increase in savings and long-term investments due to enlarged activity by participants of the derivative market.

src: i.ytimg.com

Assessment

Market price and arbitrage free

Two common value measures are:

• The market price, ie the price at which a merchant is willing to buy or sell a contract
• Price is free of arbitration, meaning there is no risk-free profit that can be done with trading in this contract (see rational price )

Specify market price

For exchange-traded derivatives, the market price is usually transparent (often published in real time by the exchange, based on all current offers and offers placed on a particular contract at a time). Complications can arise with OTC contracts or traded floors, because trades are handled manually, making it difficult to broadcast prices automatically. Particularly with OTC contracts, there is no central exchange to build and spread prices.

Specifying arbitrage-free price

View List of financial topics # Price derivatives.

The price of free arbitration for derivative contracts can be tricky, and there are many different variables to consider. The price of free arbitrage is a central topic of financial mathematics. For futures/forward, the arbitration-free price is relatively easy, involving the underlying price along with the carry fee (the revenue received minus the interest cost), although there can be complexity.

However, for more complex options and derivatives, pricing involves the development of complex pricing models: understanding the stochastic process of underlying asset prices is often important. The key equation for the optional theoretical assessment is the Black-Scholes formula, which is based on the assumption that the cash flows from European stock options can be replicated with a sustainable buying and selling strategy using only stocks. The simplest version of this valuation technique is the binomial option model.

OTC represents the biggest challenge in using models for price derivatives. Because these contracts are not publicly traded, no market price is available to validate theoretical judgments. Most of the results of the model depend on the input (meaning the final price depends on how we get the price input). Therefore, it is common that OTC derivatives are respected by Independent Agencies that the two parties involved in the agreement indicate in advance (when signing the contract).

src: www.zerohedge.com

Criticism

Derivatives are often subject to the following criticisms:

Hidden tail risk

According to Raghuram Rajan, former chief economist of the International Monetary Fund (IMF), "... it may be that managers of these companies [investment funds] have found a correlation between the various instruments they hold and believe, but as Chan and others (2005) point out, the summer lesson of 1998 after the Russian government's debt default is that a normal or zero-negative correlation can change overnight into one - a phenomenon they call "phase-in. "The hedge position can become unprotected at the worst of times, causing huge losses to those who mistakenly believe they are protected."

Risk

The use of derivatives can cause huge losses due to the use of leverage, or loans. Derivatives allow investors to derive great results from small movements in underlying asset prices. However, investors can lose a significant amount if the underlying price moves significantly. There are examples of major losses in the derivatives market, as follows:

• American International Group (AIG) lost more than US $ 18 billion through subsidiaries over the previous three quarters on credit default swaps (CDSs). The Federal Reserve Bank of the United States announced the creation of a secured credit facility of up to US $ 85 billion, to prevent a corporate collapse by allowing AIG to fulfill its obligation to provide additional collateral to its credit default credit exchange partner.
• The loss of US $ 7.2 Billion by Socià © à © tÃÆ'Ã… © gÃÆ'  © nÃÆ'  © rale in January 2008 due to misuse of futures contracts.
• The loss of US $ 6.4 billion in failed funds, Amaranth Advisors, which was a long natural gas in September 2006 when prices plummeted.
• The loss of US $ 4.6 billion in the failure of the Long-Term Capital Management Fund in 1998.
• Loss of US $ 1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.
• Loss of equity equivalent worth US $ 1.2 billion in 1995 by Barings Bank.
• UBS AG, Switzerland's largest bank, suffered a $ 2 billion loss through unauthorized trading discovered in September 2011.

It reached a staggering $ 39.5 billion, the majority in the past decade after the Commodity Futures Modernization Act of 2000 was passed.

Opponent's risk

Some derivatives (especially swaps) expose investors to counterparty risk, or risks arising from others in financial transactions. Different types of derivatives have different opponent risk levels. For example, standardized stock options by law require those at risk of having a certain amount kept in exchange, indicating that they can pay for any loss; banks that help businesses switch variables with fixed interest rates on loans can carry out credit checks on both sides. However, in private agreements between two companies, for example, there may be no benchmark for conducting due diligence and risk analysis.

Notional big value

Derivatives typically have a notional great value . Thus, there is a danger that its use may result in losses that can not be compensated by investors. The possibility that this could cause a chain reaction occurring in the economic crisis is shown by renowned investor Warren Buffett in the 2002 annual report Berkshire Hathaway. Buffett calls them 'weapons of mass destruction'. The potential problem with derivatives is that they consist of an increasing number of assets that can cause distortions in the underlying capital and equity markets themselves. Investors are beginning to see the derivatives market to make a decision to buy or sell securities so what was originally intended to be a market for risk transfer is now a leading indicator (See Berkshire Hathaway Annual Report for 2002)

src: s-media-cache-ak0.pinimg.com

Financial Reform and Government Regulation

Under US law and law in most other developed countries, derivatives have special legal exceptions that make it a very attractive legal form to grant credit. The strong creditor protection afforded to the derivative counterparties, in combination with the complexity and lack of transparency, can lead to capital markets lowering credit risk. This can contribute to a credit boom, and increase systemic risk. Indeed, the use of derivatives to conceal credit risk from third parties while protecting counterparty derivatives contributed to the 2008 financial crisis in the United States.

In the context of the 2010 ICE Trust inspection, the industry's governing body, Gary Gensler, chairman of the Commodity Futures Trading Commission, which regulates most derivatives, is quoted as saying that the derivative market as it functions now "adds up to higher costs for all Americans." More oversight banks in this market are needed, he said. In addition, the report says, "[t] he Department of Justice is looking for derivatives as well.The department's antitrust unit is actively investigating 'the possibility of anti-competitive practices in clearing derivatives, trade and information services industries,' according to department spokesman. "

For legislators and committees responsible for financial reforms related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative derivative activities has been a trivial challenge. The difference is important because regulation should help isolate and limit speculation with derivatives, especially for "systemically significant" institutions whose negligence can be large enough to threaten the entire financial system. At the same time, legislation should enable responsible parties to protect risks without being too tied up in working capital as a guarantee that companies can better hire elsewhere in their operations and investments. In this case, it is important to distinguish between financial (eg banks) and non-financial end-users from derivatives (eg real estate development firms) because the use of this company's derivatives is inherently different. More importantly, a reasonable guarantee that secures these different partners can be very different. The difference between these companies is not always straight forward (eg hedge funds or even some private equity firms do not fit into either category). Finally, even financial users must be differentiated, since 'large' banks can be classified as "systemically significant" whose derivative activities should be more closely watched and restricted than smaller, local and regional banks.

Over-the-counter transactions will be less common as the Dodd-Frank Wall Street Reform and Consumer Protection Act come into force. The specific swap clearing mandate law on the stock exchange is enacted and imposes various restrictions on derivatives. To implement Dodd-Frank, CFTC developed new rules in at least 30 areas. The Commission determines which swaps are required to be cleared and whether derivative exchanges are eligible to remove certain types of swap contracts.

Nevertheless, the above challenges and other challenges of the rule-making process have delayed the full implementation of legislation aspects related to derivatives. The challenges are further complicated by the need to organize global financial reforms among countries comprising the world's major financial markets, the main responsibility of the Financial Stability Board whose progress is ongoing.

In the US, in February 2012, the combined efforts of the SEC and CFTC have resulted in more than 70 proposed and final derivative rules. However, both have postponed the application of some derivative rules due to other regulatory burdens, litigation and opposition to the rules, and many core definitions (such as "swap," "security-based exchange," "swap dealers," "swap-based dealers," " "major swap participants" and "major security-based swap participants") have not yet been adopted. SEC Chairman Mary Schapiro argues: "Ultimately, it probably does not make sense to align everything [between SEC and CFTC rules] because some of these products are very different and of course the market structure is very different." On February 11, 2015, the Securities and Exchange Commission (SEC) released the final two rules toward establishing a public reporting and disclosure framework for data on security-based swap transactions. Both rules are not fully aligned with requirements with CFTC requirements.

In November 2012, the SEC and the regulators from Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore and Switzerland met to discuss OTC derivative market reforms, as approved by leaders in the 2009 G- 20 Summit Pittsburgh in September 2009. In December 2012, they released a joint statement stating that they recognize that the market is a global market and "strongly support the adoption and enforcement of strong and consistent standards within and across jurisdictions", with the objective of risk mitigation , increasing transparency, protecting against market misuse, preventing regulatory disparities, reducing potential arbitrage opportunities, and encouraging the playing field level for market participants. They also agree on the need to reduce regulatory uncertainty and provide market participants with sufficient legal and regulatory clarity by avoiding, as far as possible, the application of rules that conflict with similar entities and transactions, and minimizing inconsistent and duplicative application of rules.. At the same time, they note that "complete harmonization - perfect alignment of rules across jurisdictions" will be difficult, due to jurisdictional differences in law, policy, market, time of implementation, and legislative and regulatory processes.

On December 20, 2013, CFTC provides information on determining the "comparison" of its swap-setting ability. This release discusses CFTC cross-border adherence exclusions. Particularly aimed at the level of any entity and in some cases the transaction-level requirements in the six jurisdictions (Australia, Canada, EU, Hong Kong, Japan, and Switzerland) are found to be comparable to the rules themselves, thus allowing non-US swap dealers, principals and foreign branches of the US Swap Dealers and major swap participants in this jurisdiction to comply with local rules in lieu of Commission rules.

Reporting

The mandatory reporting rules are being finalized in a number of countries, such as the Dodd Frank Act in the US, European Market Infrastructure Regulations (EMIR) in Europe, as well as regulations in Hong Kong, Japan, Singapore, Canada and other countries. The OTC Regulator Forum (ODRF), a group of over 40 regulators worldwide, provides a trade repository with a set of guidelines on data access to regulators, and the Financial Stability Board and CPSS IOSCO also make recommendations related to reporting.

Source of the article : Wikipedia