BASICS OF DERIVATIVES

A derivative is a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The most simple example is a call option on a stock. In the case of a call option, the risk is that the person who writes the call (sells it and assumes the risk) may not be in business to live up to their promise when the time comes. In standarized options sold through the Options Clearing House, there are supposed to be sufficient safeguards for the small investor against this.

Before discussing derivatives, it's important to describe their basis. All derivatives are based on some underlying cash product. These "cash" products are:

* Spot Foreign Exchange. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US), so you make or lose money.

* Commodities. These include grain, pork bellies, coffee beans, orange juice, etc.

* Equities (termed "stocks" in the US)

* Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest / floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra-national organisations such as the World Bank, and companies. Negotiable means that they may be freely traded without reference to the issuer of the security. That they are debt securities means that in the event that the company goes bankrupt. bond-holders will be repaid their debt in full before the holders of unsecuritised debt get any of their principal back.

* Short term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity "Short" term is usually defined as being up to 1 year in maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and "long term" anything above that.

* Over the Counter ("OTC") money market products such as loans / deposits. These products are based upon borrowing or lending. They are known as "over the counter" because each trade is an individual contract between the 2 counterparties making the trade. They are neither negotiable nor securitised. Hence if I lend your company money, I cannot trade that loan contract to someone else without your prior consent. Additionally if you default, I will not get paid until holders of your company's debt securities are repaid in full. I will however, be paid in full before the equity holders see a penny.

Derivative products are contracts which have been constructed based on one of the "cash" products described above. Examples of these products include options and futures. Futures are commonly available in the following flavours (defined by the underlying "cash" product):

* commodity futures
* stock index futures
* interest rate futures (including deposit futures, bill futures and government bond futures)

For more information on futures, please see the article in this FAQ on futures.

In the early 1990s, derivatives and their use by various large institutions became quite a hot topic, especially to regulatory agencies. What really concerns regulators is the fact that big banks swap all kinds of promises all the time, like interest rate swaps, froward currency swaps, options on futures, etc. They try to balance all these promises (hedging), but there is the big danger that one big player will go bankrupt and leave lots of people holding worthless promises. Such a collapse could cascade, as more and more speculators (banks) cannot meet their obligations because they were counting on the defaulted contract to protect them from losses.

All of this is done off the books, so there is no total on how much exposure each bank has under a specific scenario. Some of the more complicated derivatives try to simulate a specific event by tracking it with other events (that will usually go in the same or the opposite direction). Examples are buying Japan stocks to protect against a loss in the US. However, if the usual correlation changes, big losses can be the result.

The big danger with the big banks is that while they can use derivatives to hedge risk, they can also use them as a way of taking ON risk. Not that risk is bad. Risk is how a bank makes money; for example, issuing loans is a risk. However, banks are forbidden from taking on risk with derivatives. It's just too easy for a bank to hedge bonds with derivatives that don't have the same maturity, same underlying security, etc. so the correlation between the hedge and the risky position is weak.

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