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What is a derivative?
A derivative is a financial instrument whose value is derived from an underlying asset, commodity or index. A derivative comprises a contract between two parties who agree to take action in the future if certain conditions are met, most commonly to exchange an item of value. Futures, options and swaps are common derivatives.
Investors use derivatives to manage risk, to speculate and to obtain leverage. These contracts are “derived” from an underlying asset such as a stock, bond, index or commodity. At their simplest, a derivative contract is a deal between two parties to exchange the underlying asset if the price of the asset achieves an agreed-upon level at some point in the future.
The original derivatives were crop futures, which helped farmers hedge the risks stemming from price fluctuations and demand. A farmer would sign a contract with a middleman to sell his crop at the end of the season at an agreed-upon price; if the market price for the crop was lower, the middleman would take the loss and the farmer would benefit, but if the market price was higher, the middleman would benefit by selling the crop at a higher price in the market. Either way, the farmer was able to plan based on a steady, fixed price for his product. Futures and options remain the chief way that commodities of all kinds are priced and traded.
When applied to financial markets, derivative contracts allow market participants to price risk and speculate endlessly. Instead of commodities, financial derivatives are based on stocks, bonds, currencies, interest rates and indices. Consider the options market: traders write a contract that specifies the holder will have the option but not the obligation to buy a certain amount of stock in the future if the stock achieves a specified price, and the writer of the option will have the obligation to sell the stock to the holder. Once the contract has been created, it may be sold to another party. The contract derives its value from the performance of a given stock.
- Options: Options simply mean giving the buyer the option but not the obligation to purchase or sell an asset at a specified date and price. Puts and calls are common options contracts.
- Swaps: A contract to exchange cash flows at some point in the future. The parties to a swap agree to exchange debts or assets to control various risk factors. Credit default swaps (CDS) and interest rate swaps are very common varieties.
- Futures and forwards: Agreements to purchase or sell assets on a particular date and price. Futures are standardized contracts traded on exchanges, while forwards are highly customized and traded over the counter (OTC).
- Collateralized debt obligation (CDO): These are securities that are based on pooled debt. Investors buy CDOs in order to gain cash flows from the repayment of the underlying loans that make up the CDO. Mortgage-backed securities (MBS) and asset-backed commercial paper (ABCP) are very common CDOs.
Derivatives are traded over the counter or on public exchanges. Privately traded, over-the-counter derivatives are generally more complicated and tailored to individual needs. The market for OTC derivatives can be opaque, with the structure of the products being built and exchanged kept secret. Exchange-traded derivatives are generally standardized products that are traded on specialized derivatives exchanges, with much more openness than the OTC market.
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Many analysts and economic historians assert that derivatives, specifically collateralized debt obligations and credit default swaps, were a primary cause of the 2008 financial crisis. Derivatives in the form of CDOs and CDS were first created in the 1970s and 1980s to help financial companies better understand and manage risk, but deregulation of financial markets in the 1990s opened up the use of such derivatives for speculative purposes.
Before the proliferation of inexpensive computer technology, it had been very difficult to create and price complicated derivative contracts, but this problem was more or less solved by the 1990s, thanks also to the Black-Scholes equation. Mortgage-backed securities became very common investment products. Instead of using derivatives to effectively balance risk, institutional traders began buying them up as ways to create leverage and take on much more risk. When the U.S. housing market began to crumble in 2006 and 2007, MBS investments spread throughout the banking system began to rapidly lose value, precipitating the crisis.