In [[finance]], a '''derivative''' is a [[contract]] that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an [[asset]], [[Index fund|index]], [[currency]], or [[interest rate]], and is often simply called the "'''underlying"'''.<ref>{{cite report |title=Derivatives |publisher= [[Office of the Comptroller of the Currency]], [[U.S. Department of Treasury]] |url=https://occ.gov/topics/supervision-and-examination/capital-markets/financial-markets/derivatives/index-derivatives.html |access-date=February 15, 2013 |quote = A derivative is a financial contract whose value is derived from the performance of some underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, or equity prices. Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof.}}</ref><ref>[http://www.investopedia.com/terms/d/derivative.asp "Derivative Definition"], [[Investopedia]]</ref> Derivatives can be used for a number of purposes, including [[insuring]] against price movements ([[Hedge (finance)#Etymology|hedging]]), increasing exposure to price movements for [[speculation]], or getting access to otherwise hard-to-trade assets or markets.<ref>{{cite ssrnSSRN|last1 = Koehler |first1= Christian| title=The Relationship between the Complexity of Financial Derivatives and Systemic Risk|pages =10–11|ssrn =2511541|date= May 31, 2011}}</ref>

Some of the more common derivatives include [[Forward contract|forwards]], [[Futures contract|futures]], [[Option (finance)|options]], [[Swap (finance)|swaps]], and variations of these such as synthetic [[collateralized debt obligation]]s and [[credit default swap]]s. Most derivatives are traded [[over-the-counter (finance)|over-the-counter]] (off-exchange) or on an exchange such as the [[Chicago Mercantile Exchange]], while most [[insurance]] contracts have developed into a separate industry. In the [[United States]], after the [[2007–2008 financial crisis of 2007–2009]], there has been increased pressure to move derivatives to trade on exchanges.

Derivatives are one of the three main categories of financial instruments, the other two being [[Equity (finance)|equity]] (i.e., stocks or shares) and [[debt]] (i.e., [[Bond (finance)|bonds]] and [[mortgages]]). The oldest example of a derivative in history, attested to by [[Aristotle]], is thought to be a contract transaction of [[olive]]s, entered into by ancient Greek philosopher [[Thales]], who made a profit in the exchange.<ref>{{cite book |first1=George |last1=Crawford |first2=Bidyut |last2=Sen |url= https://books.google.com/books?id=NIIVeirctosC&pg=PA7 |title=Derivatives for Decision Makers: Strategic Management Issues |publisher= John Wiley & Sons |year=1996 |isbn=9780471129943 |access-date=2016-06-15}}</ref> However, Aristotle did not define this arrangement as a derivative but as a monopoly (Aristotle's Politics, Book I, Chapter XI). [[Bucket shop (stock market)|Bucket shops]], outlawed [[Commodity Exchange Act|in 1936]] in the US, are a more recent historical example.

{{Unreferencedmore citations needed| section|date=NovemberJuly 20182023}}

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the [[notional amount]]) under which payments are to be made between the parties.<ref name="hull"/><ref>{{cite book |last= [[Mark Rubinstein]] |title= Rubinstein on Derivatves|year=1999Derivatives |publisher=Risk Books |year=1999 |isbn=978-1-899332-53-3}}</ref> The [[assets]] include [[Commodity|commodities]], [[stock]]s, [[bond (finance)|bond]]s, [[interest rates]] and [[currencies]], but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm's [[capital structure]], e.g., bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm's assets, but this is unusual outside of technical contexts.

From the economic point of view, financial derivatives are cash flows that are conditioned [[stochastic]]ally and discounted to present value. The [[market risk]] inherent in the [[underlying asset]] is attached to the financial derivative through contractual agreements and hence can be traded separately.<ref name="ssrn.com">{{cite ssrnSSRN|last1=Koehler|first1=Christian|title=The Relationship between the Complexity of Financial Derivatives and Systemic Risk|pages=10|ssrn=2511541|date=May 31, 2011}}</ref> The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the [[market value]] of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows derivative designers to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.<ref name="ssrn.com"/>

Still, even these scaled-down figures represent huge amounts of money. For perspective, the budget for total expenditure of the United States government during 2012 was $3.5 trillion,<ref name="2012actual">{{cite book | url= http://www.cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdf | title =The Budget and Economic Outlook: Fiscal Years 2013 to 2023 |publisher= [[Congressional Budget Office]]| access-date=March 15, 2013 |date=February 5, 2013}}</ref> and the total current value of the U.S. stock market is an estimated $23 trillion.<ref>{{cite news | title = Swapping bad ideas: A big battle is unfolding over an even bigger market | newspaper = The Economist | date = April 27, 2013 | access-date = May 10, 2013 | url = https://www.economist.com/news/finance-and-economics/21576681-big-battle-unfolding-over-even-bigger-market-swapping-bad-ideas }}</ref> Meanwhile, the worldglobal annual Gross Domestic Product is about $65 trillion.<ref>{{cite news | title = World GDP: In search of growth| newspaper = The Economist | date = May 25, 2011 | access-date = May 10, 2013 | url = https://www.economist.com/blogs/dailychart/2011/05/world_gdp | publisher = Economist Newspaper Ltd.}}</ref>

At least for one type of derivative, [[Creditcredit default swap|Credit Default Swaps]]s (CDS), for which the inherent risk is considered high {{By whom|date=August 2017}}, the higher, nominal value remains relevant. It was this type of derivative that investment magnate [[Warren Buffett]] referred to in his famous 2002 speech in which he warned against "financial weapons of mass destruction".<ref>{{citation|title=Buffett warns on investment 'time bomb'|date=March 4, 2003|publisher=BBC|url=http://news.bbc.co.uk/2/hi/2817995.stm}}</ref> CDS notional value in early 2012 amounted to $25.5 trillion, down from $55 trillion in 2008.<ref>{{cite web|title=600,000,000,000,000?|url=https://www.questia.com/read/1G1-187503475|publisher= Newsweek Inc. |last1= Sheridan |first1= Barrett|date=April 2008}}{{dead link|date=July 2021}}</ref>

Speculative trading in derivatives gained a great deal of notoriety in 1995 when [[Nick Leeson]], a trader at [[Barings Bank]], made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the [[Kobe earthquake]], Leeson incurred a $1.3 billion loss that [[Bankruptcy|bankrupted]] the centuries-old institution.<ref name="lee">[http://news.bbc.co.uk/2/hi/business/375259.stm "How Leeson broke the bank"], ''BBC Economy''</ref>

The true proportion of derivatives contracts used for hedging purposes is unknown,<ref>{{cite journal|author1=Sergey Chernenko|author2=Michael Faulkender|title=The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps|journal=The Journal of Financial and Quantitative Analysis|date=December 2011|volume=46|issue=6|pages=1727–1754|doi=10.1017/S0022109011000391|citeseerx=10.1.1.422.7302|s2cid=13928534}}</ref> but it appears to be relatively small.<ref>Knowledge@Wharton (2012). [http://knowledge.wharton.upenn.edu/article.cfm?articleid=709 "The Changing Use of Derivatives: More Hedging, Less Speculation"]</ref><ref>{{cite ssrnSSRN|last=Guay |first=Wayne R. |last2=Kothari |first2=S.P. |year=2001 |ssrn=253036 |title=How Much do Firms Hedge with Derivatives?}}</ref> Also, derivatives contracts account for only 3–6% of the median firms' total currency and interest rate exposure.<ref name="knowledge.wharton.upenn.edu">Knowledge@Wharton (2006). [http://knowledge.wharton.upenn.edu/article.cfm?articleid=1346 "The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch?"]</ref> Nonetheless, we know that many firms' derivatives activities have at least some speculative component for a variety of reasons.<ref name="knowledge.wharton.upenn.edu"/>

# [[Option (finance)|Options]]: 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 a [[put 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. Options are of two types: [[call option]] and [[put option]]. The buyer of a call option has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, but he has no obligation to carry out this right. Similarly, the buyer of a put option has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, but he has no obligation to carry out this right.

# [[Swap (finance)|Swaps]]: 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 exchange]], stocks or other assets. Another term which is commonly associated with ''swap'' is ''[[swaption]]'', a term for what is basically an option on the forward swap. Similar to call and put options, swaptions are of two kinds: ''receiver'' and ''payer''. In the case of a receiver swaption there is an option wherein one can receive fixed and pay floating; in the case of a payer swaption one has the option to pay fixed and receive floating.

Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2&nbsp;trillion,<ref name='ISDA Annual Chart'>{{cite web |url=http://www.isda.org/statistics/pdf/ISDA-Market-Survey-annual-data.pdf |title=Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987–present |access-date=April 8, 2010 |publisher=[[International Swaps and Derivatives Association]] (ISDA) |archive-url=https://web.archive.org/web/20120307124122/http://www.isda.org/statistics/pdf/ISDA-Market-Survey-annual-data.pdf |archive-date=March 7, 2012 |url-status=dead }}</ref> falling to $26.3&nbsp;trillion by mid-year 2010<ref name="test">[http://www.isda.org/statistics/recent.html "ISDA 2010 Mid-Year Market Survey"] {{Webarchive|url=https://web.archive.org/web/20110913153054/http://www.isda.org/statistics/recent.html |date=September 13, 2011 }}. Latest available a/o March 1, 2012.</ref> but reportedly $25.5<ref>{{cite web |url=http://www.isdacdsmarketplace.com/market_statistics |title= ISDA: CDS Marketplace |publisher=Isdacdsmarketplace.com |date=December 31, 2010 |access-date=March 12, 2012 |archive-date=January 19, 2012 |archive-url=https://web.archive.org/web/20120119141741/http://www.isdacdsmarketplace.com/market_statistics |url-status=dead }}</ref>&nbsp;trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.<ref name="IMF254">{{cite journal |title=Credit Derivatives: Systemic Risks and Policy Options |journal= IMF Working Papers |date=November 2009|first=John |last=Kiff |author2=Jennifer Elliott |author3=Elias Kazarian |author4=Jodi Scarlata |author5 =Carolyne Spackman |volume= 09|issue=WP/09/254 |pages= 1|doi= 10.5089/9781451874006.001 |s2cid= 167560306 |url= http://www.imf.org/external/pubs/ft/wp/2009/wp09254.pdf |access-date=April 25, 2010 }}</ref> During the [[Financial crisis of 2007–2010|2007–20102007–2008 financial crisis]], the lack of transparency in this large market became a concern to regulators as it could pose a [[systemic risk]].<ref name='Deutsche Bank Report'>{{cite journal|title=Credit default swaps: Heading towards a more stable system|journal=Deutsche Bank Research: Current Issues|date=December 21, 2009|author1=Christian Weistroffer|author2=Deutsche Bank Research|url=http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000252032.pdf|access-date=April 15, 2010|archive-date=February 2, 2010|archive-url=https://web.archive.org/web/20100202200136/http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000252032.pdf|url-status=dead}}</ref>

A closely related contract is a [[futures contract]]; they [[Futures contract#Futures versus forwards|differ in certain respects]]. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.<ref>[[Wikinvesthttps:Forward//www.wikinvest.com/Forward_Contract Contract|Forward Contract on Wikinvest]]{{Dead link|date=September 2024 |bot=InternetArchiveBot |fix-attempted=yes }}</ref> Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures—such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded [[Over-the-counter (finance)|over the counter]] ([[Over-the-counter (finance)|OTC]]), forward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.{{Clarify|date=November 2009}} In other words, the terms of the forward contract will determine the collateral calls based upon certain "trigger" events relevant to a particular counterparty such as among other things, credit ratings, value of assets under management or redemptions over a specific time frame (e.g., quarterly, annually).

Unlike an [[option (finance)|option]], both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures [[position (finance)|position]] can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss..

Although options valuation has been studied since the 19th century, the contemporary approach is based on the [[Black–Scholes model]], which was first published in 1973.<ref>{{cite journal |first=Eric |last=Benhamou |title= Options pre-Black Scholes |url=http://www.ericbenhamou.net/documents/Encyclo/Pre%20Black-Scholes.pdf |access-date=December 26, 2014 |archive-date=October 10, 2015 |archive-url=https://web.archive.org/web/20151010195626/http://www.ericbenhamou.net/documents/Encyclo/Pre%20Black-Scholes.pdf |url-status=dead }}</ref>{{Unreliable source?|date=August 2013}}<ref>{{cite journal |last1 =Black |first1= Fischer |first2= Myron |last2=Scholes |year=1973 |title=The Pricing of Options and Corporate Liabilities |journal =[[Journal of Political Economy]] |volume=81 |issue=3 |pages=637–654 |jstor=1831029 |doi=10.1086/260062|s2cid= 154552078 }}</ref>

In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative [[market participant]].<ref>{{cite web|title=Currency Derivatives: A Beginner's Module|url=http://www.nseindia.com/education/content/module_ncfm.htm|access-date=October 12, 2011|archive-date=August 30, 2011|archive-url=https://web.archive.org/web/20110830112932/http://nseindia.com/education/content/module_ncfm.htm|url-status=dead}}</ref>

Derivatives are often subject to the following criticisms; particularly since the [[Financial2007–2008 financial crisis of 2007–2008]], the discipline of [[Risk management]] has developed attempting to address the below and other risks - see {{slink|Financial risk management#Banking}}.

}}</ref>

{{morefurther|Leverage (finance)#Risk}}

:* [[American International Group]] (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on [[credit default swap]]s (CDSs).<ref>{{cite news|last=Kelleher |first=James B.|url=https://www.reuters.com/article/newsOne/idUSN1837154020080918 |title="Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters |publisher=Reuters.com |date= September 18, 2008|access-date=August 29, 2010}}</ref> The United States [[Federal Reserve System|Federal Reserve Bank]] announced the creation of a secured credit facility of up to US$85&nbsp;billion, to prevent the company's collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners.<ref>{{cite webnews |last1=Andrews url|first1=Edmund L. |last2=de https://wwwla Merced |first2=Michael J.nytimes.com/2008/09/17/business/17insure.html |last3=Walsh title|first3=Mary Williams |date=September "16, 2008 |title=Fed's $85 billion Loan Rescues Insurer" | website work= [[The New York Times]] |url=https://www.nytimes.com/2008/09/17/business/17insure.html}}</ref>

:*UBS AG, Switzerland's biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September 2011.<ref>{{cite magazine|url=http://www.businessweek.com/news/2011-09-15/ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson.html |archive-url=https://web.archive.org/web/20121030175804/http://www.businessweek.com/news/2011-09-15/ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson.html |url-status=dead |archive-date=October 30, 2012 |title=UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson |magazine=Businessweek |date=September 15, 2011 |access-date=March 5, 2013}}</ref>

===Counter partyCounterparty risk===

Some derivatives (especially swaps) expose investors to [[Credit risk#Counterparty risk|counterparty risk]], or risk arising from the other party in a financial transaction. Counterparty risk results from the differences in the current price versus the expected future settlement price.<ref>{{Cite journal |last1=Wu |first1=Weiou |last2=G. McMillan |first2=David |date=2014-07-08 |title=The dependence structure in credit risk between money and derivatives markets: A time-varying conditional copula approach |url=https://www.emerald.com/insight/content/doi/10.1108/MF-07-2013-0184/full/html |journal=Managerial Finance |language=en |volume=40 |issue=8 |pages=758–769 |doi=10.1108/MF-07-2013-0184 |issn=0307-4358}}</ref> Different types of derivatives have different levels of counter party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form to extend credit. The strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency however, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to conceal credit risk from third parties while protecting derivative counterparties contributed to the [[2007–2008 financial crisis of 2008]] in the United States.

In the U.S., by February 2012 the combined effort of the SEC and CFTC had produced over 70 proposed and final derivatives rules.<ref name="lexology1">{{cite web|author=Proskauer Rose LLP |url=http://www.lexology.com/library/detail.aspx?g=e7db9a60-9fca-449b-850b-b4a32d1e425d |title=SEC and CFTC oversight of derivatives: a status report |date = February 6, 2012|publisher=Lexology |access-date=March 5, 2013}}</ref> However, both of them had delayed adoption of a number of derivatives regulations because of the burden of other rulemakingrule-making, litigation and opposition to the rules, and many core definitions (such as the terms "swap", "security-based swap", "swap dealer", "security-based swap dealer", "major swap participant" and "major security-based swap participant") had still not been adopted.<ref name="lexology1"/> SEC Chairman [[Mary Schapiro]] opined: "At the end of the day, it probably does not make sense to harmonize everything [between the SEC and CFTC rules] because some of these products are quite different and certainly the market structures are quite different."<ref>{{cite news |last=Younglai |first=Rachelle |url=http://in.reuters.com/article/idINIndia-40440620090619 |title=Interview – Not all SEC, CFTC rules must be harmonized |work=Reuters |access-date=March 5, 2013 |archive-date=March 6, 2016 |archive-url=https://web.archive.org/web/20160306172405/http://in.reuters.com/article/idINIndia-40440620090619 |url-status=dead }}</ref> On February 11, 2015, the Securities and Exchange Commission (SEC) released two final rules toward establishing a reporting and public disclosure framework for security-based swap transaction data.<ref>{{cite web |url=http://www.pwc.com/en_US/us/financial-services/regulatory-services/publications/assets/sec-swap-reporting-and-disclosure.pdf |title= First take: Ten key points from the SEC's swaps reporting and disclosure rules |publisher= PwC Financial Services Regulatory Practice, February 2015}}</ref> The two rules are not completely harmonized with the requirements with CFTC requirements.

On December 20, 2013, the CFTC provided information on its swaps regulation "comparability" determinations. The release addressed the CFTC's cross-border compliance exceptions. Specifically it addressed which entity level and in some cases transaction-level requirements in six jurisdictions (Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland) it found comparable to its own rules, thus permitting non-US swap dealers, major swap participants, and the foreign branches of US Swap Dealers and major swap participants in these jurisdictions to comply with local rules in lieu of Commission rules.<ref>{{cite web |url= http://www.pwc.com/en_US/us/financial-services/regulatory-services/publications/assets/fs-reg-brief-dodd-frank-cftc-derivatives.pdf |title= Derivatives: A first take on cross-border comparability |date=December 2013}}</ref>

* {{cite ssrnSSRN|author1=Andrei N. Soklakov|title=Deriving Derivatives |date=2013|ssrn= 2262941 }}

* [https://www.cfainstitute.org/-/media/documents/support/programs/investment-foundations/11-derivatives.ashx?la=en&hash=6BA234D6843721715BA6CB45332CE2D90FC1D75C ''Investment-foundations: Derivatives'']. {{Webarchive|url=https://web.archive.org/web/20201027181218/https://www.cfainstitute.org/-/media/documents/support/programs/investment-foundations/11-derivatives.ashx?la=en&hash=6BA234D6843721715BA6CB45332CE2D90FC1D75C |date=October 27, 2020 }},. [[CFA Institute]].

* [https://web.archive.org/web/20140219012612/http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm "European Union proposals on derivatives regulation – 2008 onwards"] (archived 19 February 2014)