The derivatives market is the

financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial marke ...

for

derivative In mathematics, the derivative is a fundamental tool that quantifies the sensitivity to change of a function's output with respect to its input. The derivative of a function of a single variable at a chosen input value, when it exists, is t ...

s -

financial instrument Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership, interest in an entity or a contractual right to receive or deliver in the form ...

s like futures contracts or options - which are derived from other forms of

assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...

. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different, as well as the way they are traded, though many market participants are active in both. The derivatives market in Europe has a

notional amount The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...

of €660 trillion.

Participants in a derivative market

Participants in a derivative market can be segregated into four sets based on their trading motives. * Hedgers * Speculators * Margin Traders *

Arbitrage Arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more marketsstriking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which th ...

urs

Types of trades in a derivative market

* Directional Trades * Spreads * Arbitrage positions * Hedged Trades

Futures markets

Futures exchanges, such as Euronext.liffe and the

Chicago Mercantile Exchange The Chicago Mercantile Exchange (CME) (often called "the Chicago Merc", or "the Merc") is an American derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board ...

, trade in standardized derivative contracts. These are options contracts, swaps contracts and

futures contract In finance, a futures contract (sometimes called futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item tr ...

s on a whole range of

underlying In finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements: # an item (the "underlier") that can or must be bou ...

products. The members of the exchange hold positions in these contracts with the exchange, who acts as central

counterparty A counterparty (sometimes contraparty) is a Juristic person, legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the ...

. When one party goes

long Long may refer to: Measurement * Long, characteristic of something of great duration * Long, characteristic of something of great length * Longitude (abbreviation: long.), a geographic coordinate * Longa (music), note value in early music mens ...

(buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another is a type of a zero sum game. The total

of all the outstanding positions at the end of June 2004 stood at $53

trillion ''Trillion'' is a number with two distinct definitions: *1,000,000,000,000, i.e. one million 1,000,000, million, or (ten to the twelfth Exponentiation, power), as defined on the long and short scales, short scale. This is now the meaning in bot ...

(source:

Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution which is owned by member central banks. Its primary goal is to foster international monetary and financial cooperation while serving as a bank for central bank ...

(BIS)

. That figure grew to $81 trillion by the end of March 2008 (source: BI

Over-the-counter markets

Tailor-made derivatives, not traded on a futures exchange are traded on over-the-counter markets, also known as the OTC market. These consist of

investment bank Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

s with traders who make markets in these derivatives, and clients such as

hedge fund A hedge fund is a Pooling (resource management), pooled investment fund that holds Market liquidity, liquid assets and that makes use of complex trader (finance), trading and risk management techniques to aim to improve investment performance and ...

commercial bank A commercial bank is a financial institution that accepts deposits from the public and gives loans for the purposes of consumption and investment to make a profit. It can also refer to a bank or a division of a larger bank that deals with whol ...

government-sponsored enterprise A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress. Their intended function is to enhance the flow of Credit (finance), credit to targeted sectors of the economy, to make tho ...

s, etc. Products that are always traded

over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid pres ...

are swaps,

forward rate agreement In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular, it is a linear IRD with strong associations with interest rate swaps (IRSs). General description A forward rate agreement's (FRA's) effective desc ...

forward contract In finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument.John C Hu ...

credit derivative In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the ''credit risk''"The Economist ''Passing on the risks'' 2 November 1996 or the risk of an event of default of a corp ...

s, accumulators etc. The total

of all the outstanding positions at the end of June 2004 stood at $220 trillion (source: BIS

. By the end of 2007 this figure had risen to $596 trillion and in 2009 it stood at $615 trillion (source: BIS

OTC Markets are generally separated into two key segments: the customer market and the interdealer market. Customers almost exclusively trade through dealers because of the high search and transaction costs. Broker-dealer, Dealers are large institutions that arrange transactions for their customers, utilizing their specialized knowledge, expertise, and access to capital. In order to hedge the risks incurred by transacting with customers, dealers turn to the interdealer market, or the exchange-traded markets. Dealers can also trade for themselves or act as market makers in the OTC market (source: Federal Reserve Bank of Chicag

.

Netting

US: Figures below are from the second quarter of 200

* Total derivatives (notional amount): $182.2 trillion (second quarter, 2008) ** Interest rate contracts: $145.0 trillion (86%) ** Foreign exchange contracts: $18.2 trillion(10%) ** 2008 Second Quarter, banks reported trading revenues of $1.6 billion * Total number of commercial banks holding derivatives: 975 Positions in the OTC derivatives market have increased at a rapid pace since the last triennial survey was undertaken in 2004. Notional amounts outstanding of such instruments totalled $516 trillion at the end of June 2007 (according to the

br>
, 135% higher than the level recorded in the 2004 survey (Graph 4). This corresponds to an annualised compound rate of growth of 34%, which is higher than the approximatively 25% average annual rate of increase since positions in OTC derivatives were first surveyed by the BIS in 1995. Notional amounts outstanding provide useful information on the structure of the OTC derivatives market but should not be interpreted as a measure of the riskiness of these positions. Gross market values, which represent the cost of replacing all open contracts at the prevailing market prices, have increased by 74% since 2004, to $11 trillion at the end of June 2007

(page 28) Notional amounts outstanding as of December 2012 are $632 trillion as per recent survey.

Role in the 2008 financial crisis

The derivative markets played an important role in the

2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...

. Credit default swaps (CDSs), financial instruments traded on the over the counter derivatives markets, and

mortgage-backed securities A mortgage-backed security (MBS) is a type of asset-backed security (an "Financial instrument, instrument") which is secured by a mortgage loan, mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals ( ...

(MBSs), a type of securitized debt were notable contributors. The leveraged operations are said to have generated an "irrational appeal" for risk taking, and the lack of clearing obligations also appeared as very damaging for the balance of the market. More specifically, interdealer collateral management and risk management systems proved to be inadequate. The G-20's proposals for financial markets reform all stress these points, and suggest: *higher capital standards *stronger risk management *international surveillance of financial firms' operations *dynamic capital rules.

References

External links

Understanding Derivatives: Markets and Infrastructure
– Federal Reserve Bank of Chicago *

PBS The Public Broadcasting Service (PBS) is an American public broadcaster and non-commercial, free-to-air television network based in Arlington, Virginia. PBS is a publicly funded nonprofit organization and the most prominent provider of educat ...

( WGBH, Boston)
"The Warning"
Frontline TV public affairs program, October 20, 2009. "At the center of it all he finds

Brooksley Born Brooksley Elizabeth BornCalifornia Births, 1905 - 1995Brooksley Elizabeth Born/ref> (born August 27, 1940) is an American attorney and former public official who, from August 26, 1996, to June 1, 1999, was chair of the Commodity Futures Trading C ...

, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008." {{DEFAULTSORT:Derivatives Market Derivatives (finance) Financial markets