Help! What is a Derivative?

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Derivatives are financial contracts (financial instruments) whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, stocks, residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions). Credit derivatives are based on loans, bonds or other forms of credit.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

Three major classes of derivatives:

1. Futures: Contract to buy or sell an asset on or before a future date at a price specified today. It is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold. (Similarly, but with an important difference, a forward contract is a non-standardized contract written by the parties themselves.)

2. Options are contracts that give the owner the right, but not the obligation, to buy or sell an asset. (A call option is an option to buy, a put option is an option to or sell). The price at which the sale takes place is known as the strike price and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.

3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

Wikipedia is criticised for being unreliable and suceptible to manipulation. But say what you will about Wikipedia, if you want to get a feel for what Financial Derivatives are then take a look at this: Wikipedia - Financial Derivatives

1997 article by Cato Institute seemingly arguing for less regulation of Financial Derivatives: 10 Myths about Derivatives

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Greenspan Legacy

The Reckoning - Taking Hard New Look at a Greenspan Legacy - Series - NYTimes.com: "George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003.


“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004

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• The Reckoning: Taking Hard New Look at a Greenspan Legacy