DERIVATIVES: FUTURES, OPTIONS, FORWARDS, COMMODITIES, SWAPS, AND SECURITIES

Derivatives are products, instruments, or securities which are derived from another security, cash market, index, or another derivative. The base is referred to as the benchmark. By establishing the benchmark, one can try to evaluate the related derivatives.

Some common derivatives are: the Foreign Exchange (FOREX) or Currency Forward Markets; the Financial Futures Markets; the Commodities Futures Markets; the Options Markets; the Collateralized Obligations Markets; and the Swaps Markets. Sometimes, derivatives are called "Contingent Claims" because they are dependent on variables which influence the valuation process.

Derivatives are interrelated. For example, in currencies, there is a cash or spot forex market, a bank forward market, a currency futures market, options on actual or cash currencies, options on currency futures, swaps on currencies, instruments on stocks or shares (ADRs), options on swaps (swaptions) and so on.

Some of the defining elements are: Exactly, What is the base? What happens upon termination or exercise? Is it a standardized, exchange traded product? Or, is it an over-the-counter (OTC) instrument?

Derivatives are used for risk management, investing, and speculative purposes. Important institutional users are: banks, brokers, dealers, B/Ds, mutual funds, investment companies, insurers, producers, and other organizations which have financial interests and exposures.

Often derivative instruments are used to adjust the risk exposures or profiles of actual or cash securities. For example, a bond house may have numerous long positions in the marketplace but the level of risk and/or regulatory capital consumption is viewed as too high. Therefore, the firm may sell municipal bond futures against it long muni bond inventory, purchase puts against its long treasury position, sell calls against a basket of corporate bonds (portfolio), sell forwards or TBAs (to be announced) mortgage backed instruments against mortgages or mortgage backed securities, and swap out of floating rate exposures into fixed rate obligations.

One key reason for the existence of derivatives is to modify risk exposures by creating instruments which directly offset or hedge a position or indirectly, but acceptably, offset a position (cross-hedge).

Another reason for derivatives is that they serve as proxies for offsetting market values or unacceptable options characteristics. Also, some securities may be difficult to borrow in order to implement a risk management short sale. At such times, derivatives can be valuable alternatives.

One group of popular derivatives for individuals and institutions alike are OPTIONS: PUTS AND CALLS.

For more information, this online site contains many references for Derivatives. The following list highlights some of these references.