A derivative is a financial instrument whose value derives from that of an underlying security, also called an underlier or cash instrument, such as a stock, an index or currency.
There are two basic kinds of derivatives, exchange-traded derivatives and over-the-counter derivatives. Futures and options are the most common exchange-traded derivatives.
Over-the-counter derivatives most commonly traded are interest rate and other swaps often described in popular media as "arcane".
Credit derivatives are based on loans, bonds or other forms of credit.
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.
Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.
Trading in financial derivatives grew so rapidly during the 1990s' stock boom that former Federal Reserve chairman Alan Greenspan in 1999 described their expansion during that decade as "[b]y far the most significant event in finance during the past decade." Such growth, he concluded, meant that "both banks and nonbanks will need to continually reassess whether their risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly."
Since then, however, both exchange-traded and OTC derivatives have garnered bad press for their supposed role in recent economic shakeouts, including the credit crunch that resulted from the 2007 collapse of the mortgage-backed securities market. Negative comments from renowned financial traders like George Soros and Warren Buffett have been widely circulated and spawned several conspiracy-theory websites about derivatives and their trading. Such disinformation has been countered by some analysts who have hailed their benefits for financial markets and opposed reactionary regulations.
- ↑ Derivative Instrument. RiskGlossary.com.
- ↑ Remarks by Chairman Alan Greenspan Before the Futures Industry Association, Boca Raton, Florida March 19, 1999. Federal Reserve.
- ↑ Gambling on derivatives. Roy Davies.
- ↑ 10 Myths About Financial Derivatives. Cato Institute.