DO YOU KNOW WHAT IS DERIVATIVE?

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties’ contractual obligations, and the notional amount) under which payments are to be made between the parties.The assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm’s capital structure, e.g., bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm’s assets, but this is unusual outside of technical contexts.

From the economic point of view, financial derivatives are cash flows, that are conditioned stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.

There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded through specialized derivatives exchanges 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 eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile.

Derivatives may broadly be categorized as “lock” or “option” products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate swaps) provide the buyer the right, but not the obligation to enter the contract under the terms specified.

Derivatives can be used either for risk management (i.e. to “hedge” by providing offsetting compensation in case of an undesired event, a kind of “insurance”) or for speculation (i.e. making a financial “bet”). This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.

Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. 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 2012.

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