These are are contracts, such as options and futures, whose price is derived from the price of an underlying financial asset which is the security or property or loan agreement that an option gives the option holder the right to buy or to sell.
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Posted 31 January 2007 - 11:25 AM
"I'd rather be vaguely right than precisely wrong." J.M.Keynes
Posted 05 February 2007 - 09:44 PM
The word derivative means something derived, that which has something else as its defining factor. A financial derivative is such a thing, and has a referent as its defining essence. In general, we assume that its defining point has at least one quantifiable attribute. Often, there is more than one attribute that define the derivative. The most salient feature of a financial derivative is that it is a contract, and thus is determined by the terms of that contract. As a contract, a derivative is virtually unlimited in the number and character of terms used to express the contract. However, limiting the scope of what is practicably offered as a contract between two parties, as a financial transaction, we can develop a framework for understanding. Importantly, we can start by limiting the concept of a derivatives financial transaction as a transaction between two parties, and that while this transaction may or may not have ancillary conditional clauses that require or effect additional parties, these clauses are to be handled as separate, if subordinated, derivatives contracts. Financial derivatives may be standardized and traded on an exchange, or they may be traded OTC (over-the-counter) where the two parties agree on terms that may or may not be similar to standardized contracts. With an exchange traded derivative, the counter-party risk is mediated by the exchange, with an OTC derivative, the counterparty risk is between the two parties alone, and the payout is only guaranteed by the viability of the designated party to pay. The first attribute in financial derivatives is the reference, which must be quantifiable at a reference level. Most commonly this is a thing, a stock or commodity or abstract, such as weather, for which there is an agreed upon source for the reference's quantitative level. The derivative is then classified as a derivative of that thing, and included in the definition is the reference to the quantitative level to be used to define that thing, and the agreed upon source which records the quantitative level we are interested in. In this sense, we are not limited to financial instruments, but to anything that can have an agreed upon quantitative level: GDP, unemployment%, price of a first class letter in the USA, or more complex expressions, such as 20 year bond bps over real inflation, 4Q –3Q growth in US (GDP - ((births-deaths)-immigration)*avg wages, football game score, et al. The second important element of a derivative is the relationship of the derivative reference level to its referent reference level, and when the relationship is to be measured. This can be 1:1, >, <, or any other formula, taken at one point in time or many points in time. The third element, as a transaction, is the term structure, the time limits of validity of the transaction: a start date and end date, and possibly, dates at which the two parties are obliged to make certain measures, transactions or cash flow exchanges, depending on some attribute of the referent, or a time and date when the contract parameters may be changed, renewed or terminated. The fourth element is the entitlement that the derivative bestows. This entitlement is effected by our second element above, and it can be defined as nothing – the derivative is merely a measure, or it can be a rules based expression defining the obligations between the parties to the contract, e.g. the cash flows, and may or may not include further conditions. Similarly, there is the premium, quantity and currency at which both parties are willing to contract for the derivative, given the preceding qualifications and entitlements. The price can be an out-right currency value, either fixed or conditional, or it can consist of a value and a barter, where the barter is a construct pertaining to another financial instrument, or indeed, another derivative, and is also either fixed or conditional. Quantity and currency are self-explanatory, but may be derived themselves by a set of contractual dependencies, e.g. for both the premium and the payout. The last element is that of limitation – a set of circumstances which alter the terms of the derivative relationship or the relationship of the two parties, up to and including the termination of these relationships. Important, but non-financial attributes are the place of contract, delivery methods and types, the governing law, and whether arbitration is stipulated – however, while this does not effect the valuation of the contract per se, it needs to be recorded – implicitly in exchange traded vehicles, or explicitly for OTC derivatives. The most common form of derivative is an option, which can be used to model (price, etc.) many other types of derivatives. Other common forms of derivatives are swaps, futures, FRAs, MBS, CDS, stuctured products, etc.