DERIVATIVES

http://en.wikipedia.org/wiki/Derivative_(finance) DEFINATION :In finance, a derivative is a financial instrument whose value depends on other, more basic, underlying variables[1] Such a variable is called an "underlying" and can be a traded asset, for example, a stock orcommodity, but can also be something which is impossible to trade, such as the temperature (in the case ofweather derivatives), unemployment rate, or any kind of (economical) index. A derivative is essentially a contract whose payoff depends on the behavior of some benchmark. The most common derivatives are futures,options, and swaps. Derivatives are usually broadly categorized by: the relationship between the underlying asset and the derivative

(e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange

derivatives, interest rate derivatives, commodity derivatives or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile.

Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

USES
Derivatives are used by investors to: provide leverage (or gearing), such that a small movement in the underlying value can

cause a large difference in the value of the derivative; speculate and make a profit if the value of the underlying asset moves the way they

expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level); out; obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., hedge or mitigate risk in the underlying, by entering into a derivative contract whose

value moves in the opposite direction to their underlying position and cancels part or all of it

weather derivatives); create option ability where the value of the derivative is linked to a specific condition or

event (e.g., the underlying reaching a specific price level).

TYPES
There are three major classes of derivatives:

1.

Futures/Forwards are contracts to buy or sell an asset on or before a future date

at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

2.

Options are contracts that give the owner the right, but not the obligation, to buy

(in the case of a call option) or sell (in the case of aput option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

3.

Swaps are contracts to exchange cash (flows) on or before a specified future

date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

Examples
The overall derivatives market has five major classes of underlying asset: interest rate derivatives (the largest) foreign exchange derivatives credit derivatives equity derivatives commodity derivatives

Some common examples of these derivatives are: CONTRACT TYPES UNDERLYING Exchangetraded futures Exchange-traded options OTC swap OTC forward OTC option

Equity

DJIA Index future Single-stock future

Option on DJIA Index Equity swap future Single-share option

Back-to-back Repurchase agreement

Stock option Warrant Turbo warrant

Interest rate

Option on Eurodollar future Eurodollar future Euribor future Option on Euribor future

Interest rate swap

Forward rate agreement

Interest rate cap and floor Swaption Basis swap Bond option

Credit

Bond future

Option on Bond future

Credit default swap Repurchase Total return agreement swap

Credit default option

Foreign exchange

Currency future

Option on currency Currency Currency swap future forward

Currency option

Commodity

WTI crude oil futures

Weather derivatives

Commodity swap

Iron ore forward Gold option contract

Other examples of underlying exchangeables are: Property (mortgage) derivatives Economic derivatives that pay off according to economic reports[9] as measured and

reported by national statistical agencies Freight derivatives Inflation derivatives

Weather derivatives Insurance derivatives[citation needed] Emissions derivatives[10

Market and arbitrage-free prices

contracts; see rational pricing. BENIFITS The use of derivatives also has its benefits: Derivatives facilitate the buying and selling of risk, and many people[who?] consider this to

have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility. Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he

believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.[citation needed]

History In 12th century France the courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers. A common misbelief is that in late 13th century Brugescommodity traders gathered inside the house of a man called Van der Beurze, and in 1309 they became the "Brugse Beurse", institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building in Antwerp where those gatherings occurred;[6] the Van der Beurze had Antwerp, as most of the merchants of that period, as

their primary place for trading. The idea quickly spread around Flanders and neighboring counties and "Beurzen" soon opened in Ghent and Amsterdam. In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens. Italian companies were also the first to issue shares. Companies in England and the Low Countries followed in the 16th century. The Dutch East India Company(founded in 1602) was the first joint-stock company to get a fixed capital stock and as a result, continuous trade in company stock emerged on the Amsterdam Exchange. Soon thereafter, a lively trade in various derivatives, among which options and repos, emerged on the Amsterdam market. Dutch traders also pioneered short selling - a practice which was banned by the Dutch authorities as early as 1610.[7] There are now stock markets in virtually every developed and most developing economies, with the world's biggest market being in the United States, United Kingdom, Japan, India, China, Canada, Germany's (Frankfurt Stock Exchange), France, South Korea and the Netherlands.[8]
[edit]

Derivative instruments
Main article: Derivative (finance) Financial innovation has brought many new financial instruments whose pay-offs or values depend on the prices of stocks. Some examples are exchange-traded funds (ETFs), stock index and stock options, equity swaps, single-stock futures, and stock index futures. These last two may be traded on futures exchanges (which are distinct from stock exchangestheir history traces back to commodities futures exchanges), or traded over-the-counter. As all of these

products are only derived from stocks, they are sometimes considered to be traded in a (hypothetical) derivatives market, rather than the (hypothetical) stock market. [edit]Leveraged

strategies

Stock that a trader does not actually own may be traded using short selling; margin buying may be used to purchase stock with borrowed funds; or, derivatives may be used to control large blocks of stocks for a much smaller amount of money than would be required by outright purchase or sales. [edit]Short

selling

Main article: Short selling In short selling, the trader borrows stock (usually from his brokerage which holds its clients' shares or its own shares on account to lend to short sellers) then sells it on the market, hoping for the price to fall. The trader eventually buys back the stock, making money if the price fell in the meantime and losing money if it rose. Exiting a short position by buying back the stock is called "covering a short position." This strategy may also be used by unscrupulous traders in illiquid or thinly traded markets to artificially lower the price of a stock. Hence most markets either prevent short selling or place restrictions on when and how a short sale can occur. The practice of naked shorting is illegal in most (but not all) stock markets. [edit]Margin

buying

Main article: margin buying In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks' value. In the United States, the margin requirements have been 50 %% for many years (that is, if you want to make a $1000 investment, you need to put up $500, and there is often a maintenance margin below the $500). A margin call is made if the total value of the investor's account cannot support the loss of the trade. (Upon a decline in the value of the margined securities additional funds may be required to maintain the account's equity, and with or without notice the margined security or any others within the account may be sold by the brokerage to protect its loan position. The investor is responsible for any shortfall following such forced sales.) Regulation of margin requirements (by the Federal Reserve) was implemented after the Crash of 1929. Before that, speculators typically only needed to put up as little as 10 percent (or even less) of the total investment represented by the stocks purchased. Other rules may include the

prohibition of free-riding: putting in an order to buy stocks without paying initially (there is normally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim). [edit]New

issuance

Main article: Thomson Financial league tables Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a 29.8 %% increase over the $389 billion raised in 2003.Initial public offerings (IPOs) by US issuers increased 221 %% with 233 offerings that raised $45 billion, and IPOs in Europe, Middle East and Africa (EMEA) increased by 333 %%, from $ 9 billion to $39 billion. [edit]Investment

strategies

Main article: Stock valuation One of the many things people always want to know about the stock market is, "How do I make money investing?" There are many different approaches; two basic methods are classified as either fundamental analysis or technical analysis. Fundamental analysis refers to analyzing companies by their financial statements found in SEC Filings, business trends, general economic conditions, etc. Technical analysis studies price actions in markets through the use of charts and quantitative techniques to attempt to forecast price trends regardless of the company's financial prospects. One example of a technical strategy is the Trend following method, used by John W. Henry and Ed Seykota, which uses price patterns, utilizes strict money management and is also rooted in risk control and diversification. Additionally, many choose to invest via the index method. In this method, one holds a weighted or unweighted portfolio consisting of the entire stock market or some segment of the stock market (such as the S&P 500 or Wilshire 5000). The principal aim of this strategy is to maximize diversification, minimize taxes from too frequent trading, and ride the general trend of the stock market (which, in the U.S., has averaged nearly 10 %%/year, compounded annually, since World War II). [edit]Taxation Main article: Capital gains tax According to much national or state legislation, a large array of fiscal obligations are taxed for capital gains. Taxes are charged by the state over the transactions, dividends and capital gains on the stock market, in particular in the stock exchanges. However, these fiscal obligations may vary from jurisdictions to jurisdictions because, among other reasons, it could be assumed

that taxation is already incorporated into thestock price through the different taxes companies pay to the state, or that tax free stock market operations are useful to boost economic growth.