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Derivatives are financial instruments whose values are "derived" from the price of an asset such as stocks, corporate bonds, municipal bonds, treasury bonds, notes and bills, commodities, currencies, mortgages, precious metals, real estate and bank certificates of deposit. A derivative instrument can also be based on the index volume of the asset. The instrument is a contract which will give one party a claim on an underlying asset (or the cash value of an underlying asset) at some point of time in the future, and bind a counterparty to meet a corresponding liability. The contract might describe an amount of a currency, or a security, or a physical commodity, or a stream of payments, or a market index. It might bind both parties equally, or offer one party an option to exercise, or it may provide for assets or obligations to be swapped. Some derivatives can be traded on exchanges; their market price will, of course, depend in part on the movement of the price of the underlying asset since the contract was created. The purpose of such instruments is to allow a bank, company or investor to manage their risk by hedging (insuring themselves) against adverse price or rate movements in volatile markets.
In short, a derivative is a contractual relationship established by two (or more) parties where payment is based on (or "derived" from) some agreed-upon benchmark. When one enters into a derivative product arrangement, the medium and rate of repayment are specified in detail. For instance, repayment may be in currency, securities or a physical commodity such as gold or silver. Similarly, the amount of repayment may be tied to movement of interest rates, stock indexes or foreign currency. More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. These investment managers may decide that it is more beneficial to assume a specific "risk" characteristic of a security.
Derivative products also may contain leveraging. These features act to multiply the impact of some agreed-upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly a party's total repayment obligation.
Derivatives are supposed to be tailor made to the hedging needs of the purchaser, however they can also be utilized in a completely speculative manner. Off balance sheet derivative contracts are those that generally do not involve booking assets or liabilities (i.e. swaps, futures, forwards and options).
Derviatives include:
When derivative instruments / products first began to appear, many financial institutions began to set up (commencing in 1992) special purpose, bankruptcy remote / separately capitalized subsidiary operations known as a structured Derivative Products Company (DPC). The "structure" refers to if the entity or sponsor was downgraded there was either a "termination" provision where the contracts are marked-to-market (valuation date is established) and terminated or a "continuation" provision where new business ceased andthe existing positions were hedged and then wound down. Both of these entities engage in mirror transactions with their parent / sponsor. Another type of structure is the fully-supported or guaranteed DPC, which may have collateral provided to cover out-of-the-money positions in the event of a wind down.
