Derivatives

A derivative is a generic term for specific types of investments from which payoffs over time are derived from the performance of assets (such as commodities, shares or bonds), interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index of weather conditions).



This performance can determine both the amount and the timing of the payoffs. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. The main types of derivatives are futures, forwards, options and swaps.

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:

  • Over-the-counter (OTC) derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 298 trillion (as of 2005).
  • Exchange-traded derivatives are those derivatives products that are traded via Derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world’s largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade. According to BIS, the combined turnover in the world’s derivatives exchanges totalled USD 344 trillion during Q4 2005.

Common contract types

There are three major classes of derivatives:

  • Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
  • Options, which are contracts that give the buyer the right (but not the obligation) to buy or sell an asset at a specified future date.
  • Swaps, where the two parties agree to exchange cash flows.

Examples

Some common examples of these derivatives are:

UNDERLYING CONTRACT TYPE
Exchange traded futures Exchange traded options OTC swap OTC forward OTC option
Equity Index DJIA Index future
NASDAQ Index future
Option on DJIA Index future
Option on NASDAQ Index future
n/a Back-to-back n/a
Money market Eurodollar future
Euribor future
Option on Eurodollar future
Option on Euribor future
Interest rate swap Forward rate agreement Interest rate cap and floor
Swaption
Basis swap
Bonds Bond future Option on Bond future n/a Repurchase agreement Bond option
Single Stocks Single-stock future Single-share option Equity swap Repurchase agreement Stock option
Warrant
Turbo warrant
Foreign exchange FX future Option on FX future Currency swap FX forward FX option
Credit n/a n/a Credit default swap n/a Credit default option

Source: Wikipedia, the free encyclopedia

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