a- Fundamentals and Market Characteristics
2.1 Basics of derivatives
Derivatives are totally different from securities. They are financial instruments that are mainly used to protect against and manage risks, and very often also serve arbitrage or investment purposes, providing various advantages compared to securities. Derivatives come in many varieties and can be differentiated by how they are traded, the underlying they refer to, and the product type. Definition of derivatives
A derivative is a contract between a buyer and a seller entered into today regarding a transaction to be fulfilled at a future point in time, for example, the transfer of a certain amount of US dollars at a specified USD-EUR exchange rate at a future date. Over the life of the contract, the value of the derivative fluctuates with the price of the so-called “underlying” of the contract – in our example, the USD-EUR exchange rate. The life of a derivative contract, that is, the time between entering into the contract and the ultimate fulfi llment or termination of the contract, can be very long – in some cases more than ten years. Given the possible price fluctuations of the underlying and thus of the derivative contract itself, risk management is of particular importance.1) Derivatives must be distinguished from securities, where transactions are fulfilled within a few days (Exhibit 1). Some securities have derivative-like characteristics – such as certificates, warrants, or structured credit-linked securities – but they are not derivatives.2) Uses and users of derivatives
Derivatives make future risks tradable, which gives rise to two main uses for them. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporates and fi nancial institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates, interest rates etc., as shown in the box below. They serve as insurance against unwanted price movements and reduce the volatility of companies’ cash fl ows, which in turn results in more reliable forecasting, lower capital requirements, and higher capital productivity. These benefi ts have led to the widespread use of derivatives: 92 percent of the world’s 500 largest companies manage their b-The history of derivatives and derivatives market regulation
c-The Derivative Market now adays
Worldwide, in 2011, there was an estimated $1.3 quadrillion tied up in derivative contracts. Much of our collective tax dollars and public assets are tied up in the derivatives market. That means pension funds, money for education and city budgets are at risk.
We can clearly see the explosion in the derivative market from when they were deregulated. In fact, if you look at the chart you can see that the market had increased nearly 10-fold between 1999 and 2009.
Derivative buyers and sellers don't make things like cars, food or houses. They don't teach school and they don't pave roads. Derivatives are created by the financial industry for them to hedge their bets. Most Americans have never invested in a derivative contract.
However, sadly, all Americans and people worldwide have been hurt by the derivative market. Because when the big banks lost lots of money in the derivative market, the American people and people worldwide were (and are) being called on to bail them out, not to mention that people's pension funds and city and state budget monies were tied up in these markets. "Privatize the gains. Socialize the losses." That seems to be the mantra in the new world economy.
Trillions of Dollars in Derivative Products Worldwide
Notice the trillions and trillions of dollars involved in the global derivative market. If you had started spending $1,000,000 per day 2000 years ago and kept spending until now, you would still not have spent one...