At the end of June 2004, the Bank for International Settlements (BIS) reported that the total notional amount of outstanding over-the-counter (OTC) derivative positions alone totaled $220 trillion. The notional amount is the nominal amount that is used to calculate payments made on a derivative instrument. By the end of 2007, according to BIS, this had grown to $516 trillion.
What is a Derivatives Instrument?
Derivatives are financial instruments or financial securities whose value in part is derived from the value of another security, which is called the underlier. According to InvestorWords.com, an underlier is a “security or commodity which is subject to delivery upon exercise of an option contract or convertible security.”
The underlier security on a derivatives instrument can be currency, commodities, mortgages, stocks, or bonds - just about anything considered of value. Derivatives instruments can hedge any type of risk in any market. For instance, in the 17th century, the Dutch had developed a derivatives market in the coveted tulips market.
Futures Trading in the Derivatives Market
Derivatives are traded in two ways, as futures and over-the-counter (OTC).
Futures trading transactions occur around the world involving exchange trading platforms. In the United States, the Chicago Mercantile Exchange (CME) is a derivatives exchange market in futures. NYSE Euronext is an integrated platform of European and American exchanges in derivatives futures. In this type of financial market environment, the function of the exchange is to facilitate members engaged in the buying and selling of futures instruments.
Investments in a futures derivatives instruments works by one party selling a futures contract while a counter-party purchases a new futures contract. These transactions produce a position considered to be at zero, but transfers the bulk of the risk to the counter-party in the arrangement. This makes it possible to earn a return by exchanging a long position for a short position in the futures instrument.
OTC Derivative Trading
Over-the-counter derivatives trading has been described as more “tailor-made” derivatives products. They are not traded on a futures exchange such as CME or NYSE Euronext. For example, investment banks, such as Morgan Stanley, create OTC markets in their financial products. In such cases, the creator of the OTC derivatives product markets it to larger clients such as commercial banks, hedge funds, government entities, and large international investors.
The OTC derivatives market includes the buying and selling of different types of options, such as forward contracts, forward rate agreements, swaps, and credit derivatives. Trading volume activity is substantial and involves significant amounts of financial investments.
Derivatives Market Risks
As early as 2003, then U.S. Federal Reserve Board Chairman Alan Greenspan and Warren Buffet of Berkshire Hathaway, Inc. (nyse: BRK.A) participated in a discussion of the derivatives market. At the time, the entire world market for derivative instruments was estimated at $100 trillion, according to Forbes.com financial writer Ari Weinberg (05/09/03). Buffet and Greenspan both agreed that the value and risks of derivatives were difficult for even derivative instrument holders to calculate.
According to Weinberg, Buffet had "soured" on derivatives investments as inefficient and feared that the derivatives market was too risky and could adversely effect financial markets. Greenspan agreed but believed that spreading the risk from the high concentration of large firms, such as American International Group (AIG), was the solution to managing the derivatives market.
U.S. Financial Regulations Reform and the Derivatives Market
The appeal of a derivative market comes from the potential to realize a larger profit on an investment than with other financial market transactions, and the ability to transfer liability from one party to another. Since 2009, financial reform legislative efforts in the United States have included a push for greater regulation over the derivatives market.
Whether this is needed or not has been a matter of significant debate between the U.S. Senate Banking Committee and the House Financial Services Committee. In any case, potential derivatives market investors are wise to perform substantial due diligence as it relates to understanding the derivatives market and the historical performance of the underlier (underlying product) of a given derivatives instrument.
General Disclaimer: This article is for informational purposes only and should not be used as a substitute for legal or tax advice.
Vanessa Cross - Vanessa Cross is a freelance writer who writes about international trade, business law and small business development issues.
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