OTC derivatives are contracts which are privately negotiated and traded directly between two parties. Trade takes place excluding exchange and other intermediaries. Being largely unregulated when it comes to disclosure of information, the OTC derivatives market is the largest market for derivatives. Products such as swaps and forward rate agreements are examples. Given that trades happen in private, recording of OTC figures is difficult and this can be clearly noted from the Bank for International Settlement (BIS) figures. The total outstanding estimated amount is $684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. ETD contracts act as an intermediary to all related transactions. These derivatives are traded with the use of specialized derivatives exchanges. According to BIS, the combined turnover in the world’s derivatives exchanges totalled USD 344 trillion during Q4 2005. These publicly traded derivatives are distinctive from other derivatives even though they are derived from other financial instruments. Thus, even though these publicly traded derivatives are underlying, they can still be considered as distinctive because they provide to investors the access to risk, or reward, and volatility characteristics.
There are three major classes of derivatives: Futures/Forwards – Contracts to buy or sell an asset on or before a future date at today’s price. While a future contract is a standardised contract written by a clearing house that operates an exchange where the contract can be bought and sold, a forward contract is a non-standardised contract written by the parties themselves. 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, normally for Europe the maturity date. Swaps – Contracts to exchange cash on or before a specified future date based on the underlying value of the asset. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date. The underlying asset can vary amongst the following: Interest rate derivatives Foreign exchange derivatives Credit derivatives Equity derivatives Commodity derivatives
Derivatives are used to: Cause a large difference in the value of the derivative when a small movement occur in the value of the underlying asset. This is done because derivatives provide to investors leverage and gearing. Make a profit if the value of the underlying asset moves the way the investor expected it would. This is done through speculative instruments. Hedge or mitigate risk in the underlying, and this is done 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. Obtain exposure to the underlying asset where it is not possible to trade in the underlying asset itself (example weather derivatives) Create optionality where the value of the derivative is linked to a specific condition or event (example the underlying reaching a specific price level) From the cases relating to fraud being analysed under question, it was noted that the derivatives mostly used were those relating to hedge risks and those used for speculation. For this reason, more information is listed hereunder on the two. Hedging is a technique that attempts to reduce risk. With this regard, derivatives can be considered a form of insurance. Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. For example, a grape farmer and a wine maker could sign a futures contract to exchange a specified amount of cash for a specified amount of grapes in the future. Both parties have reduced a future risk: for the grape farmer, the uncertainty of the price, and for the wine maker, the availability of grapes. However, there is still the risk that no grapes will be available because of events unspecified by the contract, like the weather, or that one party will renege on the contract. From another perspective, the farmer reduces the risk that the price of grapes will fall below the price specified in the contract and acquires the risk that the price of grapes will rise above the price specified in the contract (thereby losing additional income that he could have earned). The wine maker, on the other hand, acquires the risk that the price of grapes will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of grapes will rise above the price specified in the contract. With regards to speculation, derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.
Large Possible Losses The use of leverage or borrowing can result in large losses when using derivatives. This is because investors would be earning large returns from small movements in the underlying asset’s price. On the other hand the opposite may be the result if the price of the underlying assets moves against them significantly, causing the investors to lose large amounts. Counter-Party Risk Derivatives, especially swaps, expose investors to counter-party risk. A person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates may choose to swap payments with another business who wants a variable rate. However, if the second business goes bankrupt or if interest rates increase, the businesses will be adversely affected with possible causes of bankruptcy. Unsuitably high risk for small/inexperienced investors Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. They are also attractive to individual investors because they offer possible high rewards. Speculating in derivatives require the investor to show adequate experience and market knowledge because of the dealings being made with high risks. Large estimated value There is the danger that the use of derivatives could result in losses which the investor wouldn’t be able to compensate for because of the large values being estimated. When already in an economic crisis, the possibility of chain reactions increases. A famous investor, Warren Buffett  referred to derivatives as ‘financial weapons of mass destruction.’ Distortions being created in the real capital and equity markets when using derivatives might lead to false decisions being taken.
Derivatives facilitate the buying and selling of risk; and many people consider this to have a positive impact on the economic system. However, although when using derivatives someone loses money while someone else gains money, under normal circumstances, trading in derivatives should not adversely affect the economic system.
It was noted that a major factor leading to the growth of derivatives trading in currencies was the collapse of the Breton Woods agreement in 1971 and the resulting shift from a fixed to a floating exchange rate regime. There were those who argued that when derivatives are employed correctly, derivatives can be used to reduce risk, not increase it. As such, one can conclude that derivatives are only as dangerous as the hands they are placed in.
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