Talk:Derivative (finance)

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Contents 1 Types of derivatives 2 Introductory section 3 Language 4 The title and introduction of this page are simply wrong 5 Taxman is right 6 question 7 Buffett Controversy 8 Introduction (still) does not make sense 9 Add a link 10 Tidy up etc 11 "Fair Price" is out 12 Opening definition - suggested changes 13 Options and futures - suggested changes 14 Insurance and Hedging

[edit] 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)

[edit] Introductory section

I'm having a hard time even parsing some of these sentences, and I don't see how a reader could arrive at a crisp understanding of a 'derivative security'. For example, I can't find meaning in the sentence 'The economic derivative product embedded into either of the above or into a derivative security may be the same or different, as the differences between these three products are in their legal form.' Can someone help me discover what the writer is trying to say?

"Other financial derivatives do not take the form of securities but are in the form of a bi-lateral contract that can be bought "over-the-counter" or through an exchange. The economic derivative product embedded into either of the above or into a derivative security may be the same or different, as the differences between these three products are in their legal form."

Thats sentence is confused. A derivative is bi-lateral, an agreement between two parties. Instead of "legal form" it should say, the contract can have a myriad properties. - Jerryseinfeld 01:56, 22 Dec 2004 (UTC)

[edit] 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)

[edit] 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 themselves 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)

[edit] 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)

[edit] 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.

[edit] 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)

[edit] 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)

[edit] 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)

[edit] 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)

[edit] "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)

[edit] 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)

[edit] 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.

[edit] 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.