Derivatives Paper

Topics: Derivative, Credit default swap, Derivatives Pages: 5 (2029 words) Published: February 14, 2013
Derivatives are not the easiest financial instruments to understand and they can definitely get very complex. Regardless, derivatives have a long-standing history and have grown in popularity in the financial sector. Some would be surprised to learn that derivatives actually arose many, many centuries ago and are not something that just came into importance in the last few decades. In history, derivatives have evolved into what they are today. Previously, farmers primarily utilized derivatives because they saw great risk in farming certain crops especially crops that were hard to harvest in certain areas (Chance 7). Some say though that derivatives can be traced all the way back to biblical times but it is more feasible to look at the history in the past couple of centuries (“A Brief History of Derivatives” 6). In 1570, the Royal Exchange opened in London for forward contracting and in 1690, options began trading on securities in London. It was not until 1790 though that options began trading on securities in the United States (“A Brief History of Derivatives” 6). Today, numerous companies utilize many different kinds of derivatives on several financial markets. So what exactly is a derivative? A derivative is an agreement regarding an underlying asset over a span of time, the value of which is derived from the performance of the underlying asset (Greenwald 28). Thus, a derivatives transaction is any "financial contract under which either or both of two parties agree to make payments or deliveries to the other based on the performance or change in the value of a reference rate or asset" (Greenwald 28). The underlying reference rate or asset is typically an interest rate, currency exchange rate, or a tangible commodity. Although this is typical, the underlying reference rate or asset could really be anything that is quantified and objectively verifiable (Greenwald 29). For example, an interest rate swap derives its value from one or more interest rate indexes, while the value of a stock option depends upon the value of a stock. By linking their payoffs to changes in the value of the underlying assets, derivatives enable market participants to trade in the price fluctuations of the underlying without the necessity of trading directly in that asset (Greenwald 32). Generally, derivatives fall into two basic categories, which are exchange-traded derivatives and over-the-counter (OTC) derivatives. Exchange-traded derivatives are standardized agreed upon terms and conditions that are traded through organized exchanges such as the New York Mercantile Exchange (NYMEX) (“Trader Takes the Mound” 16). Exchange-traded derivatives are generally known as futures. These futures normally have zero-credit risk because trading volumes and prices are transparent to market participants. Trading takes place on either through an “open outcry” on the trading floor with buyers and sellers calling out prices for which they wish to transact, or more commonly today, through electronic trading systems (Kilman). OTC derivatives are more private and done between a buyer and seller without the use of an organized exchange. The buyer and seller are able to then customize the agreement instead of having it be standardized like an exchange-traded derivative (Kilman). Unfortunately, both parties are exposed to risk due to the ability for either party to default on the agreement as well as prices not being as transparent as an exchange-traded derivative (“Trader Takes the Mound” 16). Exchange-traded derivatives also are exposed to risk as well through the exchange’s clearing house’s ability to default but that holds a very low risk so exchange-traded derivatives are determined to basically have zero-risk. Regardless, both markets can work side by side. For example, a derivatives dealer may look at organized exchanges to hedge risks incurred through trading in the OTC market (“Trader Takes the Mound” 16). Two basic types of OTC...
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