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 concept has an ancient lineage. But its application has expanded tremendously in recent decades. A derivative can be dangerous in the wrong hands. This is when mistakes are made or the possible perils are not properly grasped. If handled with care, it is a useful risk management tool.
The formula used in these transactions may be complex or more simple. But, as a majority these are not standardized. Transacted over the counter, they are not traded on exchanges. This can add complexity to even the simple instruments. The simple variety varies in its forms. The forward contract form is a contract to procure or sell some item at a future delivery date. A futures contract is comparable to this, but it is standardized and swapped on an exchange.
Another common type is an option to purchase or vend something for a set amount in future. This is commonly known as an options contract. Another variant, termed a swap, exchanges cashflows. There may also be combinations of such types of simple contracts. An exotic derivative involves a more complicated transaction.
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 risk can be latent because several instruments can be written on same underlying assets. This adds complexity to financial markets as the contract terms may differ considerably. The interconnectedness can be impossible for regulators and traders to discern. A demonstration is what transpired in the global financial crisis triggered by the bursting of the housing bubble. Trading was halted because there was no transparency in easily finding out which firms were safe.
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 illustrated by debacles, governments are less sophisticated. They have gotten burned from their deals. The Greek catastrophe surprised Europeans. As admitted by Greek officials, those who engaged in the deals did not comprehend the risk they were undertaking. They could not properly evaluate the hidden risks. Local governments have also found themselves in a similar fix. While the tools are useful for savvy users, derivatives are not a good resource for any party possessing shallow pockets and lacking the ability to understand the underlying risks.
This concept has an ancient lineage. But its application has expanded tremendously in recent decades. A derivative can be dangerous in the wrong hands. This is when mistakes are made or the possible perils are not properly grasped. If handled with care, it is a useful risk management tool.
The formula used in these transactions may be complex or more simple. But, as a majority these are not standardized. Transacted over the counter, they are not traded on exchanges. This can add complexity to even the simple instruments. The simple variety varies in its forms. The forward contract form is a contract to procure or sell some item at a future delivery date. A futures contract is comparable to this, but it is standardized and swapped on an exchange.
Another common type is an option to purchase or vend something for a set amount in future. This is commonly known as an options contract. Another variant, termed a swap, exchanges cashflows. There may also be combinations of such types of simple contracts. An exotic derivative involves a more complicated transaction.
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 risk can be latent because several instruments can be written on same underlying assets. This adds complexity to financial markets as the contract terms may differ considerably. The interconnectedness can be impossible for regulators and traders to discern. A demonstration is what transpired in the global financial crisis triggered by the bursting of the housing bubble. Trading was halted because there was no transparency in easily finding out which firms were safe.
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 illustrated by debacles, governments are less sophisticated. They have gotten burned from their deals. The Greek catastrophe surprised Europeans. As admitted by Greek officials, those who engaged in the deals did not comprehend the risk they were undertaking. They could not properly evaluate the hidden risks. Local governments have also found themselves in a similar fix. While the tools are useful for savvy users, derivatives are not a good resource for any party possessing shallow pockets and lacking the ability to understand the underlying risks.
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