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.
The concept has been around for centuries, but their use has exploded in the modern era. Some serious hazards have been associated with their use. But, when handled conservatively, they have been valuable in the important functional purpose of managing risk.
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 variant is an option to procure or exchange something for some predetermined amount at a future time. This is identified as an options contract. Another variation, known as a swap, is an exchange of cashflows. There could also be some mixes of simple contracts. A derivative which is an exotic involves more complicated formulas.
The more complicated an arrangement the more latent its dangers can be even for experienced participants. For instance Procter and Gamble lost 160 million dollars in 1994 on an exotic instrument. In those days this was a big loss. JP Morgan lost much more in 2012. Its loss was in excess of 6 billion dollars. Its risk also risked an uninvolved party, its customer. Disclosures revealed the trading was done using its excess of customer cash deposits on hand.
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.
However less sophisticated Governments have demonstrated they lacked the capacity to manage such arrangements. The Greek crisis was triggered by one and as admitted by Government officials the country did not understand what it was buying. It was not equipped to judge the risks or costs. The same can be said for the many local governments in different countries. Derivatives are best managed by those with deep pockets who possess the capacity to understand what they are getting into.
The concept has been around for centuries, but their use has exploded in the modern era. Some serious hazards have been associated with their use. But, when handled conservatively, they have been valuable in the important functional purpose of managing risk.
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 variant is an option to procure or exchange something for some predetermined amount at a future time. This is identified as an options contract. Another variation, known as a swap, is an exchange of cashflows. There could also be some mixes of simple contracts. A derivative which is an exotic involves more complicated formulas.
The more complicated an arrangement the more latent its dangers can be even for experienced participants. For instance Procter and Gamble lost 160 million dollars in 1994 on an exotic instrument. In those days this was a big loss. JP Morgan lost much more in 2012. Its loss was in excess of 6 billion dollars. Its risk also risked an uninvolved party, its customer. Disclosures revealed the trading was done using its excess of customer cash deposits on hand.
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.
However less sophisticated Governments have demonstrated they lacked the capacity to manage such arrangements. The Greek crisis was triggered by one and as admitted by Government officials the country did not understand what it was buying. It was not equipped to judge the risks or costs. The same can be said for the many local governments in different countries. Derivatives are best managed by those with deep pockets who possess the capacity to understand what they are getting into.
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