Derivatives pledge payoffs that are derived from the value of some other thing or things. The underlying value could be of a rate or a financial asset. But it could also be something else. They are recorded in what is termed to be notional value, which essentially equals the value of the underlying thing.
This is not a modern concept. But its use has grown exponentially in our time. It has been discovered to be a dangerous instrument when errors are made or when potential risks are not understood properly. When handled carefully, it has been useful in managing risk in an increasingly complex world.
The transactional formula involved can be basic or more complex. But, the majority of derivatives, of all types, are not standardized. They are instead transacted over the counter. The basic variety has variable forms. Among the common types is a contract to purchase or vend an item for delivery in future. This is termed a forward contract. Futures contracts are comparable to these, except they are standardized and traded on an exchange.
Also in this group are options to buy or offer for sale something for a settled price in the future. These are termed options contracts. Another variant is exchanging one cashflow for another. These are termed swaps. There can also be combinations of forward, futures and options contracts. An exotic derivative is cannot be created by mixing and matching option and forward contracts. In this variety, the payoff is a complicated function of one or many underlying things.
There is greater potential risk in more complicated arrangements. Even sophisticated parties have succumbed to the hidden pitfalls. Procter and Gamble was one such high profile victim in 1994. More recently JP Morgan found itself in a pickle. Its loss of an amount exceeding 6 billion USD was big news in 2012. Its risk risked the savings of its unsuspecting customers. Ensuing disclosure revealed loss involved trading of an excess of customer funds.
Systemic risks can be dormant because numerous instruments may be written on the same assets. This makes financial markets more opaque as the contracted terms can vary significantly. The connectedness of the market is not discernible for traders and regulators alike since they are not on exchanges. This is where the dangers can be as was demonstrated by the global financial crisis of 2008.
But, for practical reasons, such as the volatility of the financial markets, companies have sought refuge in this offered solution. Careful users have guarded against potential pitfalls by having a written policy governing their use. Such parties often insist on a credit rating of AA or better for counter parties in such transactions. A popular use is to protect against foreign currency volatility. Foreign currency fluctuations have encouraged companies to hedge their risks through such transactions. But to protect themselves careful firms tend to hedge only a small portion of their positions and most of these have short maturities of less than 90 days.
As has been demonstrated, Governments have been less sophisticated and have gotten burned badly by their involvement. In the Greek crisis this problem shocked Europe. As was admitted by Greek Government officials, those who purchased the contracts did not understand the risks involved. They were ill equipped to evaluate the potential costs. Many local governments found themselves in the same position. While these tools can be very useful, derivatives are best handled by those with can afford them and possess the ability to understand all aspects of the deal.
This is not a modern concept. But its use has grown exponentially in our time. It has been discovered to be a dangerous instrument when errors are made or when potential risks are not understood properly. When handled carefully, it has been useful in managing risk in an increasingly complex world.
The transactional formula involved can be basic or more complex. But, the majority of derivatives, of all types, are not standardized. They are instead transacted over the counter. The basic variety has variable forms. Among the common types is a contract to purchase or vend an item for delivery in future. This is termed a forward contract. Futures contracts are comparable to these, except they are standardized and traded on an exchange.
Also in this group are options to buy or offer for sale something for a settled price in the future. These are termed options contracts. Another variant is exchanging one cashflow for another. These are termed swaps. There can also be combinations of forward, futures and options contracts. An exotic derivative is cannot be created by mixing and matching option and forward contracts. In this variety, the payoff is a complicated function of one or many underlying things.
There is greater potential risk in more complicated arrangements. Even sophisticated parties have succumbed to the hidden pitfalls. Procter and Gamble was one such high profile victim in 1994. More recently JP Morgan found itself in a pickle. Its loss of an amount exceeding 6 billion USD was big news in 2012. Its risk risked the savings of its unsuspecting customers. Ensuing disclosure revealed loss involved trading of an excess of customer funds.
Systemic risks can be dormant because numerous instruments may be written on the same assets. This makes financial markets more opaque as the contracted terms can vary significantly. The connectedness of the market is not discernible for traders and regulators alike since they are not on exchanges. This is where the dangers can be as was demonstrated by the global financial crisis of 2008.
But, for practical reasons, such as the volatility of the financial markets, companies have sought refuge in this offered solution. Careful users have guarded against potential pitfalls by having a written policy governing their use. Such parties often insist on a credit rating of AA or better for counter parties in such transactions. A popular use is to protect against foreign currency volatility. Foreign currency fluctuations have encouraged companies to hedge their risks through such transactions. But to protect themselves careful firms tend to hedge only a small portion of their positions and most of these have short maturities of less than 90 days.
As has been demonstrated, Governments have been less sophisticated and have gotten burned badly by their involvement. In the Greek crisis this problem shocked Europe. As was admitted by Greek Government officials, those who purchased the contracts did not understand the risks involved. They were ill equipped to evaluate the potential costs. Many local governments found themselves in the same position. While these tools can be very useful, derivatives are best handled by those with can afford them and possess the ability to understand all aspects of the deal.
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