Talk:Derivative (finance)/Archive 1

Archive 1

Types of derivatives

This could be reorganized. There's two lists. And interest rate swaps are under both interest rate linked derivatives swaps. Futures and options are obvious categories, perhaps swaptions could go as an option and the interest rate linked derivatives under the other categories. - Jerryseinfeld 20:53, 7 Nov 2004 (UTC)

Evitavired: I have amended the first paragraph to include a broader field of the various types of derivative. I have deleted the section on futures as it is not correct. Futures are exchange traded contracts, this relates more to a desription of a forward: happy to discuss further.

and —Preceding unsigned comment added by 64.119.84.3 (talk) 02:51, 11 July 2008 (UTC)

Opening suggestion - perhaps something like this:

A commodity, (or some other kind of financial investment) packaged up, and made into a single “financial instrument” of large value. This instrument is then divided up, and sold into financial markets; originally designed to offset future risk. An analogy, is the way insurance companies (or race coarse bookmakers) off-load and spread their financial exposure. This is a simplified explanation of a derivative; they have since become a controversial investment vehicle in their own right.

Language

"A derivative is like a razor. You can use it to shave yourself and make yourself attractive for your girlfriend. You can slit her throat with it. Or you can use it to commit suicide" (Financial Times).

Hmm, I think not.--Jerryseinfeld 16:19, 30 Dec 2004 (UTC)

Oh you don't? That's nice. Why don't you tell us why. —Preceding unsigned comment added by Commonpete (talk • contribs) 15:35, 6 February 2009 (UTC)

The title and introduction of this page are simply wrong

Despite the textbook by Jarrow and Turnbull of the same name, Derivative Securities, financial derivatives are not necessarilly securities. From Wall Street Words, a security is "an instrument that, for a stock, shows ownership in a firm; for a bond, indicates a creditor relationship with a firm or with a federal, state, or local government; or signifies other rights to ownership." More intuitively, a security has identity and existence apart from its owner and is transferrable through some means, while many if not most financial derivatives are executable contracts, with no life or existence apart from the initiating counterparties.

This is not merely nitpicking; it weighs heavily (especially in the United States) upon court proceedings when things go awry. The Federal courts in the U.S. have sometimes ruled that derivatives are securities -- thus subject to the SEC Act of 1933, and sometimes ruled they are not.

As to the introduction, it neither captures what makes derivatives derivatives, or indeed includes all flavors of derivatives. I suppose rather than ranting, I should change it.

I guess it depends on whose definition of security (finance) you use. Check the bottom of that article, I have quoted the relevant section from the 1934 act. I suppose some derivative contracts would not be covered under that but it does suprise me that federal courts would rule some things would not fall under the SEC's jurisdiction. Do you have any links to show that? Either way that is the way they are commonly known, so the name of the article is still correct. The text could be altered a bit to note the discrepency you point out though.

Oh, and I forgot, the US is not the only thing that matters here. What about Europe, Asia, Oceana, etc? How do they define it? - Taxman 20:50, Mar 22, 2005 (UTC)

I favor "switching" the redirect with Derivative (finance). I believe that's a better title. Although the SE Act lists options as securities, more precise terminology doesn't always treat derivative instruments as securities. I think the rest of the world uses terminology along the lines of derivative instrument or just plain derivative.Feco 5 July 2005 18:51 (UTC)

On a related note, I think the definition sentence omits the essential part of derivatives... their price/value/cashflow profile is based (derived) on the behavior of something else. I wouldn't specify the 'something else' to be a security, b/c there are derivatives based on weather, LIBOR, unemployment, GDP, etc. Sample intro text:

A derivative is an agreement between two parties to exchange cashflows over a period of time. The specific amounts and timing of the cashflows are based contractually on the behavior of some external factor—a stock price, an interest rate or weather conditions, for example.

Feco 5 July 2005 18:51 (UTC)

I guess I'm convinced, because when thinking of it, swaps are always talked about as derivatives, but as far as I know they are never securities. Options pretty much meet the definition of securities except the private transaction types or those such as real options. I guess that makes enough exceptions to make Derivative (finance) the better place for this article. I can do that (by deleting the current redirect and moving this to that), but only if you can commit to taking care of all of the redirects, and links to this article, of which there are about 70. I won't have time to fix them myself. 2) The definition says "In finance, a derivative security is a contract that specifies the rights and obligations between the issuer of the security and the holder to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event." We could add your second sentence to make the whole thing a little clearer I guess. For anything other than a security derivative, there is not really an assigned value to it anyway. Well of course, whoever sets up the contract decides on what it is worth to them, but unless it is traded, there is not a market value for it. So the common definition of saying the value is derived from that of another security or index is of course not correct. Your first sentence also omits the case where lump sums (not usually talked about as a cash flow, even thogh it strictly is) or securites himself are exchanged. So like I said, I would suggest adding your second sentence, not replacing with your first. - Taxman ^Talk July 5, 2005 19:52 (UTC)

Derivative can make you Beggar or Billionaire - Overnite ..! —Preceding unsigned comment added by 192.18.128.5 (talk) 06:47, 27 July 2009 (UTC)

Taxman is right

I couldn't agree more with Taxman. In most cases, what people think of as derivatives aren't securities. They're contracts. The title of the section should be changed.

I forgot to respond to this. That is not what I was getting at. I think the current title is fine, and haven't yet seen any good evidence as to why it should be different. - Taxman ^Talk June 30, 2005 22:47 (UTC)

Derivatives are traded just like equities, which is what the term security implies. The contract part comes in when settling the financial aspects, which can take a while. —Preceding unsigned comment added by 76.15.45.59 (talk) 21:35, 26 August 2008 (UTC)

question

"90% of all derivatives revenue by derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable planning."

Where in the hell did this come from? can you verify this at all? Also, the assumption that LTCM and other derivative crises events have no more repercussions is astonishing. Even mere memory of the event is a repercussion let alone the recent scare over hedge fund hemoraging provoking discussion about LTCM.

Buffett Controversy

I propose the removal of Buffett commentary, since it is seen by many self-serving and hypocritical. His comments met heavy criticisms pointing to the fact that his company and its subsidiaries make heavy uses of derivatives in various forms (Currency derivatives, SQUARZ notes (specially crafted convertible bonds), etc.).

Well the Buffet comment is fairly notable, and verifiable and on topic, so why should it be removed? If you have some sources about the heavy criticism he faced for th comment, please add those and cite them. In other words, don't remove, balance. - Taxman ^Talk June 30, 2005 22:47 (UTC)

Introduction (still) does not make sense

Recently, there was a concensus here to move this page to Derivative (finance). I have changed all the links, so this can finally be done. On the more serious issue of the introduction, it is still plain wrong. It currently stands as:

In finance, a derivative security is a contract that specifies the rights and obligations between the issuer of the security and the holder to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event

1) issuer of the security implies that a derivative is always a security, which is wrong, see the Wiki-consensus above.

2) The word contract can be confusing. Most common use of the word would be a legal document. Now, is a derivative the document itself, or something more? Compare it with a mortgage. This also has a legal document defining it, but you wouldn't equate the mortgage with the mortgage contract. Further confusion can arise, as contracts are also the name of derivatives traded on an exchange (one can be 'long' 100 FTSE DEC 05 contracts, for instance - this usage doesn't exist in over-the-counter markets).

3) based on some future event is vague. Indeed, later in the entry it is stated that The terms and payments can be derived from the price of a security or commodity, a published statistics, an event (such as default on payment), or something else, which is much more general.

I like the definition that Feco gave earlier:

A derivative is an agreement between two parties to exchange cashflows over a period of time. The specific amounts and timing of the cashflows are based contractually on the behavior of some external factor—a stock price, an interest rate or weather conditions, for example.

Instead of agreement I would prefer financial product or financial instrument. The only other thing that I think should be added is that it are not necessarily cash flows that are exchanged (cf. stock options). Regarding the comments of Taxman earlier on why we should keep the current definition:

For anything other than a security derivative, there is not really an assigned value to it anyway. Well of course, whoever sets up the contract decides on what it is worth to them, but unless it is traded, there is not a market value for it. So the common definition of saying the value is derived from that of another security or index is of course not correct. (Taxman)

Firstly, I'm not quite sure what you mean with your statement that security derivatives have an assigned value, and that other derivatives don't. Do you mean exchange traded derivatives when talking about security derivatives? One can assign a value to all derivatives - as they have to be marked-to-market, this is in fact done regularly. Secondly, you are right in saying that the common definition that the value is derived from that of another security or index is not correct. However, it's not the value, but the cash flows that are determined by prices of other securities or indices.

Your first sentence also omits the case where lump sums (not usually talked about as a cash flow, even thogh it strictly is) or securites themselves are exchanged. So like I said, I would suggest adding your second sentence, not replacing with your first. (Taxman)

You're right, Feco's definition doesn't mention either exchange of principal (which is usual for cross-currency swaps), or exchange of securities against payment (as in stock options). In the first case, these are just cash flows, and in the market they ARE talked about as such. Why do you suggest they are not? In the second case, you are completely right, as per my earlier comment.

One last thing - one of the most important industry bodies in the securities industry is the Association of National Numbering Agencies. They are the guys who set guidelines for the issuance of ISIN codes, and are appointed by the ISO to do so. In [1] you'll see that they don't even consider exchange traded futures and options as securities (see 3.5 & 3.6 under the heading 'Financial instruments other than securities'.

sorry, it's all getting a bit long... all part of a drive to improve the finance pages.. DocendoDiscimus 09:58, 12 September 2005 (UTC)

Ok I made the move to coincide with all the links you fixed, so thanks for that. As for the user pages and redirects, just fix them all to link to this page now too. You don't have to do the user pages if you don't feel like it, but it is polite to keep all links correct. The categories stay with the article as it is moved so nothing needs to be done there. I've also made an effort to fix the lead according to the comments here. I think it is accurate, but we would need to check some things: 1) would all derivatives count as contracts? I think so or else people wouldn't enter them, but we should check. 2) Clarity on what are and aren't considered securities. The way I worded the lead avoids the second issue but it would be better to be acurate an not weasely, at least later in the article if not the lead. No offense, but ANNA is a an administrative body, not a regulatory one, so their take on it isn't definitive I don't think. The issue is that what is a security comes down to a regulatory issue more than anything else, and I think it would differ among jurisdictions. For ex the UK and Germany may treat them very differently from the US, so we should ideally cover all major markets if possible. Also trying to think of this, it could also be a purely legal situation, where we would have to find an attorney or legal discussion of the definition of a security. I'll see what I can dig up. - Taxman ^Talk 18:12, September 12, 2005 (UTC)

Thanks for doing the move! I'll sort out the remaining links. Before we call 0800-LAWYER, I've found some more sources. I think you're completely right - to a large extend it is purely a legal situation. In general, there are two sides - market practitioners on the one hand, and regulators on the other. The market practitioners are represented by

• ISDA on the derivative side (both in the US and Europe)
• BMA (bonds in the US)
• ICMA (bonds in Europe)

Searching the ISDA site for Securities doesn't yield anything. They clearly do not use the word security to denote a derivative. The BMA and ICMA sites don't mix up the two - as you'll see for instance in ICMA EU/US report, the words are used quite distinctly. On the regulator side, we have the SEC, the CFTC, the FSA in the UK, and the BIS. (there are many more, but these are the main ones).

• The CFTC, who are responsible for the regulation of future exchanges in the US, do not mention securities on their site, except in the case of Security Futures Products [2] (see 41.21 (a) (1) in particular). It defines securities eligible for these sfp's as either common stock or certain other equity securities. Futures Exchanges are not regulated by the SEC, (some claim this is much to their dismay), but there has been talk of greater cooperation for ages [3].
• The BIS also use the terms derivative and security completely distinctly. See for instance [4]. Though admittedly, this is mainly about OTC derivatives, and there is already a consensus that they're not considered securities.
• The SEC themselves contain in their definition of a security [5]:
  • any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities: so they say it's only a security if the underlying is one or more securities. eh.. could this be slightly circular?
  • any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency: so exchange traded currency derivatives. Would this be because these are the only Futures Exchanges they regulate?
  • any interest or instrument commonly known as a "security". Let me guess... they are the SECURITIES and exchange commission... No wonder they want to keep their options wide open.
• The FSA don't use the term derivative security anywhere on their website. Web pages of the major futures exchanges CBOT, CME and Euronext didn't give me a single mention of the word derivative security, nor of any instance where derivative and security were used for one and the same product.

Unfortunately, except from the site of the SEC, none of the sites has an actual definition of a security. I do believe we need to mention the fact, that the SEC calls certain derivatives securities. Though that should be no more than a line such as Some regulators, such as the SEC, classify certain derivatives as securities.

There's a nice matrix on financial instruments - What I've been reading confirms my view that: Products in the first column are considerd securities (except for loans, CD's&FX), in the second column are Exchange Traded Derivatives, and Over-the-Counter Derivatives in the third. All these columns are mutually exclusive.

On the issue of contracts - I think you're right, all derivatives can be considered contracts. Of course you can't say you're long 24 5 year USD swap contracts, as you can with futures, but we shouldn't confuse readers with this. Now, time to sort out the redirects... DocendoDiscimus 21:11, 12 September 2005 (UTC)

Add a link

I made my search looking for "Financial derivatives". It could be interesting to create a link for this plural form, very commonly used indeed. --84.185.133.177 13:15, 14 December 2005 (UTC)Visitor.

Done. --Sgcook 06:50, 10 January 2006 (UTC)

Tidy up etc

I've had a fair bash at trying to tidy up this page and make it a bit more readable. I haven't deleted anything major that was here previously, mostly rearranged into clear sub-sections, clarified some titles, and expanded background information. Hopefully now most of the issues raised above have already been covered.--Sgcook 13:08, 4 January 2006 (UTC)

"Fair Price" is out

I don't know who came up with the phrase "fair price" but I certainly have never heard this applied to derivatives. What the editors seem to mean is "arbitrage-free price" which is very commonly used.

I don't want to be too aggressive here but I'd only stand down if I see a couple of sources that use fair price in this context. Smallbones 15:08, 29 May 2006 (UTC)

Fair value is applicable to derivatives since it is applicable to a far larger class, namely all goods, services, and assets. When there's a market for the derivative in question, then one can estimate its fair value merely by using the market price (this is apparently the way most securities are calculated in the US and probably elsewhere). However, I agree with your assessment, the editors clearly meant "arbitrage-free" price. -- KarlHallowell 02:23, 3 July 2006 (UTC)

Opening definition - suggested changes

Apologies if this is an old discussion, but the opening sentence still seems to me to be convoluted:

"In general, a derivative is a conditional instrument used by market participants to trade or manage an asset."

A few points on this:

• "Conditional instrument" is not defined anywhere in wikipedia, so doesn't help clarity.
• Defines derivative in terms of its use, but very vaguely (trade?).
• To me, would be helpful if it also gave some sense of where the word comes from.

Would the following work and not cause major disagreements?

"In general, a derivative is a financial instrument derived from some other asset, event, condition, or thing; rather than trade or exchange the thing itself, market participants enter into an agreement to exchange cash, assets or some other value at some future date based on the underlying thing. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date."--Gregalton 11:44, 24 November 2006 (UTC)

Options and futures - suggested changes

The author seems to confuse options and futures throughout, treating them as the same contract. Options are asymmetric contracts, in which the buyer pays a premium (the option price) in order to gain the right (but not the obligation) to buy (in a call option) or sell ( in a put option) the underlying at a future point or points in time. Futures are symmetric contracts in which the two counterparties agree to exchange the underlying at a future date at a price agreed today. The price is chosen to make the current value of the futures contract zero for both sides at the time the contract is entered into, no premium is payed. In an option contract the downside risk to the buyer is limited to the option premium, the downside for the seller is potentially unlimited (for the writer of a call) or only limited by the current price of the underlying (for the writer of a put). For a future the downside risk is unlimited for both parties.

Insurance and Hedging

"It is not uncommon for farmers to walk away smiling when they have lost out in the derivatives market as the result of a hedge. In this case, they have profited from the real market from the sale of their crops. Contrary to popular belief, financial markets are not always a zero-sum game. This is an example of a situation where both parties in a financial markets transaction benefit."

This is really interesting, but should be better explained.

It is also a bit wrong and a bit one sided. Futures and Forwards are zero sum games. For every winner there is a loser. That being said, a producer [e.g. wheat farmer] and a consumer [e.g. baker] could add a future to their portfolio of farms, bakeries, etc. and reduce their exposures to price fluctuations. A farmer may want to lock in a price before he rents land, buys seed, etc. A baker might want to assure a supply of wheat 9 months after harvest. This may well make the overall portfolio's risk/return ratio much better. Alex 686 (talk) 04:30, 29 February 2008 (UTC)

a change needed?

In the "speculation and arbitrage" section, regarding the "borrowed money" example, I believe "300%" should be changed to "200%."

Ironic?

It is, indeed, ironic that something set up to prevent risk will also allow parties to expose themselves to risk of exponential proportions.

What's ironic about this? As explained in the article, one may use a derivative to transfer risk, thus protecting one person from risk while exposing another. A straight-forward explanation of how risk is transferred or at least that it is transferred would be far better than this sentence, if it is even necessary. Any suggestions?

What in the world are exponential proportions? Does the risk grow or shrink at an exponential rate? I googled this phrase and every other page containing it sounds like it is written by marketing droids and unprofessional bloggers. It doesn't belong here.

My opinion is that we should just zap this sentence completely - Savant45 03:02, 29 August 2007 (UTC)

Unclear relevance

The article secion "Insurance and Hedging" includes this sentence:

On 2005-06 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003 (Revised 2004 10K (PDF, 787 KB)).

It is unclear how this sentence relates to the objective of the section and article. Please adjust the sentence, else I may remove it.

--Philopedia 14:31, 20 September 2007 (UTC)

History

I'm not up to the task, but a brief section on the economic history of derivatives would, I think, be useful. Origins, milestones, and controversies would all fit nicely into such a section. --Peter ^Talk 01:51, 13 December 2007 (UTC)

Speculative statements

The statement "Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded." is unsupported, unreferenced and speculative, yet stated as true. If your investment is collapsing you can sell or you can hold and you do not know in advance which is the correct move. To state that they 'used incorrectly' because they sold at the wrong time is the same as saying you didn't bet on a horse race 'correctly' because you should have bet on the horse that actually won. Xj (talk) 10:32, 12 March 2008 (UTC)

I would second to get rid and/or modify this. This is not how I remember the OC default. If I remember correctly, OC got into trouble when their "intrest only strips" on "Goverment bonds" fell to zero. I poked around a bit but I could not find a good source to referance. Alex 686 (talk) 16:58, 26 March 2008 (UTC)

I added a request for citation.--Nowa (talk) 15:24, 1 July 2008 (UTC)

Portfolio

I deleted the following because I don’t believe it is correct:

’’It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. They simply derive their values from assets such as bonds, equities, currencies, etc. and are used to either hedge those assets or improve the returns on those assets.’’

A call option over shares, for example, is an investment in itself, even though its value is derived from the underlying shares. If I buy a call option I pay the premium in the hope that the price of the shares will rise and I will be able to make a profit by exercising the option. I don't see a fundamental qualitative difference between that and any other investment. The difference is quantitative - if the price goes down I lose all the money I spent on the premium, but if it goes up I stand to make a much bigger profit than if I had invested the same amount of money directly in the shares.

Accounting standards (at least IFRS and US GAAP) certainly recognize derivatives as assets (or liabilities) in themselves, and in most cases require their value to be shown on the balance sheet. --Bhuna71 (talk) 22:32, 13 November 2008 (UTC)

Value of outstanding derivatives doesn't make sense

I don't understand how the value of outstanding OTC derivatives can be over 10x higher than the world's GDP (see List of countries by GDP (nominal)). If anyone understands, could they please give a brief explanation? Thanks. New Thought (talk) 23:39, 28 November 2008 (UTC)

I can't answer that fully, but if a party pays $1m under a swap (getting an income stream in return), the entity receiving the $1m may pay it into another swap and so on - in some finacial structures there can be, say, 10 swaps, each with a nominal value of $Xm, giving a total nominal value of $10Xm - but there is actually only $Xm involved. This is very common in some areas of finance, and may account for some of it. Westmorlandia (talk) 15:26, 15 May 2009 (UTC)

Please Make At Least Part Of This Article Amenable To The Intelligent Non-Specialist

I find that in general all the Wikipedia's economic articles extremely insular. Please have a section that doesn't simply hypertext other highly technical economic articles. Imagine that you are writing for someone who is intelligent but really doesn't know anything about your subject. This is what a dictionary should provide. You can still include all your highly technical definitions later on in the article. Analogies are great. So far I have figured out that Derivatives are a sort of bet - but what is the relationship between a derivative and its underlying? They seem like they are totally separate? And what the hell do derivatives have to do with stocks? Or capitalism in general. It seems like some private betting or gambling operation. It all seems very strange.Canuckistani 22:26, 7 December 2008 (UTC)

Exactly. THIS ARTICLE IS TERRIBLE And should be rewritten in layman terms. I always have to go to investopedia or about.com to find simple definitions. —Preceding unsigned comment added by Ericg33 (talk • contribs) 08:27, 28 December 2008 (UTC)

I'm just finishing my MBA, so I'm not exactly a layman; but I agree that there are some parts of the article that could be better explained. It seems that within the financial community there is some disagreement about definitions of many terms; and I believe that this may be the source of much of the ambiguity. It's a good article, but it's a work in progress. -→ $JJOlsen$ 19:59, 5 March 2009 (UTC)

Counter-Party Risk

This section does not mention the fact that of the three types of derivatives (forward, futures, & options), most industrialized nations funnel at least 2 of the 3 types through a clearinghouse, by law. This removes counter-party risk completely, if the clearinghouse is sanctioned (insured) by the sovereign, which it typically is. The lack of mention of the role of the clearinghouse in this section introduces bias. This section should be edited accordingly. Srwm4 (talk) 20:02, 30 January 2009 (UTC)

You are allowed to edit it yourself... :P Westmorlandia (talk) 15:27, 15 May 2009 (UTC)

Clearing & central counterparties

• Per the post by User:Erdosfan on my talk page: We may be dealing with a semantic problem, as I am going on the assumption that clearing (usually) involves a central counterparty, as the Clearing (finance) entry suggests. As counterpoint (small joke!), here is an online description of CME Group's ClearPort counterparty clearing mechanism for OTC derivatives not actually traded at CME Group: http://www.nymex.com/cpc_overview.aspx (CME Group acquired NYMEX and the ClearPort feature in August 2008.) Perhaps this means these trades fall into a new, third category of neither exchange-traded nor completely over-the-counter (non-exchange traded). And thanks for your watchful comments. --RayBirks (talk) 23:40, 17 February 2009 (UTC)

RayBirks, note the CME is talking about futures, which are by definition exchange traded, in the sense that the exchange is a counterparty and liable for the contract. Forwards, however, are the OTC version of a future, not traded on an exchange.

While rooted in semantics, the distinction is crucial. Clearing has to do with information processing. Exchanges actually assume the liability for the trades that they enter. OTC derivatives lack this exchange feature, even though many are cleared through clearing houses. Erdosfan (talk) 23:54, 18 February 2009 (UTC)

GFDL Violation?

The TV show Life (NBC), contained a verbatim copy of the definition of Derivative from this page in the dialog for the show. Season 2, Episode 16. Under the GFDL, doesn't that mean that the derivative work, the episode is now covered by the GFDL? Around minute 9. —Preceding unsigned comment added by 203.97.96.78 (talk) 20:23, 17 March 2009 (UTC)

Alan Greenspan comment

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]

Should this still be there, considering that Alan recanted his believe recently. Personally, I believe it should be pulled down considering that he has recanted it and we have already observed the downturn he thought will not be forth coming

Intro still sucks

"Derivatives are financial instruments, whose prices are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be the price of an asset (e.g., commodities, equities (stock), residential mortgages, commercial real estate, loans, bonds), the value of an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items. Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwards, futures, options, and swaps.

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 take a risk and make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). This activity is known as speculation."

I have a few problems with this:

• Its the instruments that are derived, not the prices (as mentioned above)
• There is no mention of leverage, an important aspect of most derivatives (delta1 excluded)
• Credit derivatives seems kind of tacked on.
• The hedging/speculation section seems rather unclear
• Intro is supposed to be succinct, so the list of all the different types of underlying seems out of place.

How about the following (adapted from above) Gregalton 11:44, 24 November 2006 (UTC):

proposed intro

A derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying); rather than trade or exchange the underlying itself, market participants enter into an agreement to exchange cash or assets over time based on the underlying. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date.

Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

Derivatives can be used by investors to speculate and make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). Alternatively, traders can use derivatives to 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 out.

Derivatives are usually broadly categorised by:

• The relationship between the underlying and the derivative (e.g. forward, option, swap)
• The type of underlying (e.g. Equity derivatives, FX derivatives, credit derivatives)
• The market in which they trade (e.g. exchange traded or OTC)

Any comments? --119.236.156.145 (talk) 03:33, 18 July 2009 (UTC)

Definitely an improvement; your bullet list of the current lead's problems makes that clear. Could probably stand a small copyedit to simplify / break up one or two long sentences, but in all very good. --CliffC (talk) 16:10, 18 July 2009 (UTC)

I have a couple of comments:

(1) I don't think we should get hung up on using the word "derived" in the definition, as it seems to be restricting the clarity - I think that if the concept is explained, it will be obvious how the term was, er, derived.

(2) We also need to be clear that not all derivatives are instruments (i.e. OTC derivatives), but all derivatives are contracts, even exchange-traded derivatives.

(3) I think that "event", "value" and "condition" are really too wide in defining a derivative - it seems to include more or less any contract. I think that almost everything would be covered by asset, cashflow and index, but would be grateful for counter-examples.

I would suggest something like the following:

"A derivative is a contract which references an asset (often a share or a bond), a cashflow or an index, known as the "underlying". The value of a derivative varies as the value of the underlying varies, in a manner determined by the nature of the derivative contract. Derivatives are mainly used in the world of finance, as a way of hedging or leveraging a party's exposure to an investment, or as a way of gaining exposure to an investment, whether long or short, without taking ownership of an underlying asset.

Futures, options and swaps are all types of derivative. Derivatives can also be categorised as "over-the-counter" (or "OTC") derivatives, which are contracts individually negotiated and agreed between parties, and exchange-traded derivatives, which are standard contracts, structured as financial securities, which are traded on public markets."

Thoughts? Westmorlandia (talk) 12:42, 29 September 2009 (UTC)

What's your definition of "instrument"?

"A contract which references an asset" is too broad a definition. If I sign a contract to purchase a house, that is a contract that references an asset, but it is not a derivative. Maybe it should specify "financial asset"? The second paragraph looks good. Should it include forwards? Bond Head (talk) 13:17, 29 September 2009 (UTC)

I would consider a financial "instrument" to be a security - I wouldn't call an OTC contract an instrument. Though looking at some web definitions, I can see secondary definitions where "instrument" is used to mean a contract generally. Personally I would still prefer it as "contract", however, as it seems more clearly correct to me.

You're right that "references an asset" is too broad, though perhaps "financial asset" is both too narrow (are commodities "financial assets"?) and still too broad (as not all contracts referencing e.g. a share will be a derivative). Perhaps the key points to get across are (i) the underlying and (ii) the change in value over time? Is it also correct to say that derivatives also always relate to some future event (and the transfer of the risk of that event), in comparison to a spot trade, which does not?

The second paragraph was meant to give just some well-known examples, though I have no objection to adding forwards - and perhaps warrants too? Westmorlandia (talk) 19:48, 30 September 2009 (UTC)