What Are Derivatives? About Derivatives Rules

What Are Derivatives?

Basically, a derivative is a financial contract. Similar to other simple financial contracts, two people or parties enter into a contract which states the value of assets covered, the date a transfer of assets is to take place and the conditions related to the transfer. A derivative contract is always future when it is contracted. If the derivative goes to term, the transfer must take place or a default occurs.

The unique feature about derivatives is that they have what is called a notional value. A notional value is the face value of the assets involved in the contract. The reason it is called a notional value is that the transfer does not usually take place so the face value is notional or theoretical. The contract may be a hedge against a risk by one party and insurance by the other.

Some Types of Derivatives

Until recent years, derivatives were usually confined to such contracts as commodity futures or stock options. Now they can be anything from futures, options, interest rates, currency exchanges, credit, or swaps. A firm may use derivatives to keep their price of goods stable by buying derivatives in components of the product they manufacture. This assures them of the price they must pay for these components. Others use derivatives to speculate hoping to make a profit on what they think the cost of a commodity or currency may be in the future.

Where Are Derivatives Traded?

There are things about derivatives that have gained much publicity recently. One of the newsworthy discussions is about where derivatives are traded. Some are traded on exchanges and people can see the amount being asked or offered. Commodity futures are traded on the Chicago Board of Trade, for instance. There are other derivatives that are not published, nor can the average person see what they are trading for in the market. There is a move to make some derivatives more openly traded. This has led to some controversy because the largest traders in derivatives contend that this will cut into their profits.

About Derivatives Rules

A discussion about derivatives rules is not complete without a discussion of the Dodd-Frank Wall Street Reform and Consumer Protection Act. One impact of the Dodd-Frank Act, as far as derivatives are concerned, will be felt in changes to the way some derivatives are marketed. The rules are being ironed out by the Commodities Futures Trading Commission to allow open trading on swaps derivatives. They hope to implement this trading in 2012.

The Office of the Comptroller of Currency reported that the notional amount (the asset face value) of derivatives held by insured commercial banks in the U.S. amounted to $249 trillion at the end of the second quarter of 2011. Since the GDP worldwide in 2010, according to the World Bank, was $76.287 trillion, which is 3.25 times worldwide GDP. The International Swaps and Derivatives Association, Inc. reported $466.8 trillion was the notional amount of interest rate, credit, and equity derivatives outstanding at June 30, 2010.

The Act also addresses how much capital a bank will need to maintain to cover the derivatives it owns. The benefit of this is obvious because it will reduce the credit risks involved and make financial institutions more stable.