I heard a finance guy claim that there's about $400 trillion in debt based derivatives that could turn the planet into a ghetto. Finance guys,, could you comment on the effects of derivatives made from mortgages, then derivatives made from all U.S. debt please?
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Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options, and swaps.
The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) â” see inflation derivatives â” or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.
* 1 Uses
o 1.1 Hedging
o 1.2 Speculation and arbitrage
* 2 Types of derivatives
o 2.1 OTC and exchange-traded
o 2.2 Common derivative contract types
o 2.3 Examples
* 3 Portfolio
* 4 Cash flow
* 5 Valuation
o 5.1 Market and arbitrage-free prices
o 5.2 Determining the market price
o 5.3 Determining the arbitrage-free price
* 6 Criticisms
o 6.1 Possible large losses
o 6.2 Counter-party risk
o 6.3 Unsuitably high risk for small/inexperienced investors
o 6.4 Large notional value
o 6.5 Leverage of an economy's debt
* 7 Benefits
* 8 Definitions
* 9 References
* 10 See also
* 11 External links
One use of derivatives is to be used as a tool to transfer risk by taking the opposite position in the underlying asset. For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.
Also, stock index futures and options are known as derivative products because they derive their existence from actual market indices, but have no intrinsic characteristics of their own. In addition to that, one of the reasons some believe they lead to greater market volatility is that huge amounts of securities can be controlled by relatively small amounts of margin or option premiums. One reason derivatives are popular is because they can be transacted off-balance-sheet.
It must be pointed out that a primary producer (farmer, mining company, etc.) is unable to hedge in the strictest definition (eliminate risk). The producer is able to price fix the commodity by selling futures or by buying/writing options. This in no way eliminates market exposure. Example, a gold miner sells his future output by selling futures contracts. At the time he executes this position, gold is $900/troy ounce. He sells futures for ~$905/t.o.(assuming a normal/contango market, as high demand for gold can lead to backwardation,). If in 6 months the price of gold is $1000/t.o. he would have been better off not "price fixing". So there still is market exposure. This same scenario applies to a consumer.
The strictest absolute hedging practice is employed by a Merchant Banker who buys in the cash/physical market and sells in the futures market. When he later sells his commodity in the cash market and covers his futures contract(s), he has held the asset without market exposure. This can also be accomplished in conjunction with puts and calls by managing the hedge ratio (delta) to neutral.
Derivatives traders at the Chicago Board of Trade.
Derivatives traders at the Chicago Board of Trade.
 Speculation and arbitrage
Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.
In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgement on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old financial institution.