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In finance, a derivative security or derivative
is a contract which specifies the right or obligation between two parties to
receive or deliver future cash flows (or exchange of other securities or assets) based on some future
event.
Another way of defining a derivative is that it is a security whose value is determined (derived) from one or more other
securities, commodities, or events. The value is influenced by the features of
the derivative contract, which may include the timing of the contract fulfillment, the value of the underlying security or
commodity, and other factors such as volatility.
The payments between the parties may be determined by the future changes of:
- the price of some other, independently traded asset in the future (e.g., a common stock)
- the level of some index (e.g., a stock index or heating-degree-days)
- the occurrence of some well-specified event (e.g., a company defaulting)
Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a
predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the
derivative makes money; otherwise, they lose money. Depending on the definition of the contract, the potential loss or gain may
be much higher than if they had traded the underlying security or commodity directly.
Common examples of derivatives are:
Some less common, but economically intriguing, examples are:
- Economic
derivatives which pay off according to the state of the economy as measured by national statistical agencies
- Weather derivatives
Derivatives are one of the most rapidly growing and changing areas of modern finance. According to the BIS (Bank for International Settlements), as of December 2002, the "total estimated notional amount of
outstanding OTC contracts stood at $141.7
trillion."
The most common use of derivative securities is as a tool to buy and sell risk. For
example, a farmer may seek to sell a futures contract in a
commodity such as wheat at a fixed price to a speculator. The farmer reduces his risk that the price of wheat will unexpectedly
raise or fall, and the speculator assumes this risk with the possibility of a large reward.
Because derivative securities offer the possibility of large rewards, many individuals have the strong desire to invest in
derivative securities. Most financial planners caution against this, pointing out that an investor in derivative securities often
assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small
investor. One should keep in mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is
able to hedge against the risk by buying some other derivative
The central topic of financial mathematics is the fair
valuation of derivatives. One key equation used to value derivatives is the Black-Scholes Equation.
Economists generally believe that derivatives have a positive impact on the
economic system by allowing the buying and selling of risk. However, many economists are worried that derivatives may cause an
economic crisis at some point in the future. Since someone loses money while someone else gains money with a derivative security,
under normal circumstances, trading in derivatives should not adversely affect the economic system.
There is the danger, however, that someone would lose so much money that they would be unable to pay for their losses. This
might cause chain reactions which could create an economic crisis. In 2002, legendary
investor Warren Buffett commented in an interview with the New York Times that he had accumulated his wealth without the use of
derivatives and that he regarded them as 'financial weapons of mass destruction', an allusion to the phrase 'weapons of mass destruction' relating to physical
weapons which had wide currency at the time.
Although there have been instances of massive losses, most notably by Long-Term Capital Management, these have not had repercussive effects. Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact
of the economic downturn at the beginning of the 21st century.
This kind of investment gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank,
made poor and unauthorized investments in derivatives. Through a combination of poor judgment on his part, lack of oversight by
management, and unfortunate outside events, Leeson incurred a 1.3 billon dollar loss that bankrupted the centuries old financial
institution.
See also
External links
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