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   see also: shadow banking market  and International Finance markets


Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. For example, a call option is a derivative because its value is derived from the value of the underlying stock.  Actually, options are the more complicated of all derivatives.  Most of them are actually quite simple, and come in the form of futures (or forwards).


Table of Contents:




Market Size:


HUGE:  see data here:  http://www.bis.org/statistics/otcder/dt1920a.pdf


Notional amounts outstanding:  June'08 = $683,725 billion

Gross market values:                             =   $20,353 billion   (approx $21 Trillion USD!!)


Derivatives bubble explodes five times bigger in five years. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007, then to $683 trillion by June '08.   How big is that?
A comparison:
To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:
  • U.S. annual gross domestic product is about $15 trillion
  • U.S. money supply is also about $15 trillion
  • Current proposed U.S. federal budget is $3 trillion
  • U.S. government's maximum legal debt is $9 trillion
  • U.S. mutual fund companies manage about $12 trillion
  • World's GDPs for all nations is approximately $50 trillion
  • Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
  • Total value of the world's real estate is estimated at about $75 trillion
  • Total value of world's stock and bond markets is more than $100 trillion
  • BIS valuation of world's derivatives back in 2002 was about $100 trillion
  • BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion
Notional  vs Gross
  • "Notionl" value is the "maximum losses in case of a meltdown" ....and gives an idicator of the market's size
  • "gross market values" tells you the scale of financial risk transfer taking place in derivatives markets."



Types of derivatives

The diverse range of potential underlying assets and payoff alternatives leads to a huge 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) — see inflation — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the payoffs.





Why use derivatives?


The main reason is to reduce risk, by hedging.  Derivatives are tools that a company can use to cut away its risk, and to sell that risk to another firm (that is in the business of taking risk...like an insurance firm).   Remember, risk is to be avoided in business, and derivatives are one of the main tools for reducing risk.   When a firm reduces its risk using derivatives, it is hedging that risk.  The main use of derivatives is to reduce risk for one party while offering the potential for a high return (at increased risk) to another.


Another use of derivatives is for speculating, or for betting on the future prices of various assets.   This is the opposite of hedging.  If a firm wants to speculate, it is essentially increasing the risk of the firm (hoping for a bigger return).   This is not a very common or recommended strategy for companies that are risk-adverse.  Instead, this type of derivatives speculation is more common with Hedge Funds.  They might make a large one-directional bet that interest rates are going to fall by purchasing a derivate that increases in value when interest rates fall.   This can turn out to be very profitable if you are right, but also very un-profitable if you are wrong.   If you believe in the efficient market theory, then you will agree that its very hard to make money in this manner, but if you believe in behavioral finance, then good luck!




1.  Long - benefit if market price of asset goes up 

2.  Short - benefit if market price of asset goes down 



                      Forward     Type        when to use                                example

Book seller:       sells       short        if your hurt by price decrease     selling inventory

Book buyer:       buys       long        if your hurt by price increase       if purchasing for resale (and have fixed sales price)


*See the book seller example for derivatives  for an easy way to think about who is "long", and who is "short"




Why so Popular ?


Confidence in pricing gave buyers and sellers the courage to pile into derivatives. ...The idea behind quantitative finance is to manage risk. You make money by taking known risks and hedging the rest.


see alpha

see article here:  http://www.economist.com/specialreports/displaystory.cfm?story_id=12957753


World's newest and biggest 'black market'


The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.
Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.
Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.


Source:  Paul B. Farrell, MarketWatch:  http://www.marketwatch.com/news/story/derivatives-new-ticking-time-bomb/story.aspx?guid={B9E54A5D-4796-4D0D-AC9E-D9124B59D436}&print=true&dist=printTop




The International Monetary Market opened in 1972; Congress allowed trade in commodity options in 1976; S&P 500 futures launched in 1982, and options on those futures a year later. The Chicago Board Options Exchange traded 911 contracts on April 26th 1973, its first day (and only one month before Black-Scholes appeared in print). In 2007 the CBOE’s volume of contracts reached almost 1 trillion.






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