Financial derivatives definition, types, risks gasco abu dhabi address

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Stock options are traded on the NASDAQ or the Chicago Board Options Exchange. Futures contracts are traded on the Intercontinental Exchange. It acquired the New York Board of Trade in 2008. It focuses on financial contracts, especially on currency, and agricultural contracts, principally dealing with coffee and cotton. The Commodities Futures Trading Commission or the Securities and Exchange Commission regulates these exchanges. Trading Organizations, Clearing Organizations, and SEC Self-Regulating Organizations have a list of exchanges. Types of Financial Derivatives

CDOs were a primary cause of the 2008 financial crisis. These bundle debt like auto loans, credit card debt, or mortgages into a security. Its value is based on the promised repayment of the loans. There are two major types. Asset-backed commercial paper is based on corporate and business debt. Mortgage-backed securities are based on mortgages. When the housing market collapsed in 2006, so did the value of the MBS and then the ABCP.

The most common type of derivative is a swap. It is an agreement to exchange one asset or debt for a similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps or interest rate swaps. For example, a trader might sell stock in the United States and buy it in a foreign currency to hedge currency risk. These are OTC, so these are not traded on an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-rate payment stream of another company’s bond.

The most infamous of these swaps were credit default swaps. That’s because they also helped cause 2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate debt, or mortgage-backed securities. When the MBS market collapsed, there wasn’t enough capital to pay off the CDS holders. That’s why the federal government had to nationalize the American International Group. CDSs are now regulated by the CFTC.

Forwards are another OTC derivative. They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. The two parties can customize their forward a lot. Forwards are used to hedge risk in commodities, interest rates, exchange rates, or equities.

Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain price and date. The most widely used are options. The right to buy is a call option, and the right to sell a stock is a put option. Four Risks of Derivatives

Derivatives have four large risks. The most dangerous is that it’s almost impossible to know any derivative’s real value. That’s because it’s based on the value of one or more underlying assets. Their complexity makes them difficult to price. That’s the reason mortgage-backed securities were so deadly to the economy. No one, not even the computer programmers who created them, knew what their price was when housing prices dropped. Banks had become unwilling to trade them because they couldn’t value them.

Another risk is also one of the things that makes them so attractive: leverage. For example, futures traders are only required to put 2 to 10 percent of the contract into a margin account to maintain ownership. If the value of the underlying asset drops, they must add money to the margin account to maintain that percentage until the contract expires or is offset. If the commodity price keeps dropping, covering the margin account can lead to enormous losses. The CFTC Education Center provides a lot of information about derivatives.

The third risk is their time restriction. It’s one thing to bet that gas prices will go up. It’s another thing entirely to try to predict exactly when that will happen. No one who bought MBS thought housing prices would drop. That’s because the last time they did was the Great Depression. They also thought they were protected by CDS. The leverage involved meant that when losses occurred, they were magnified throughout the entire economy. Furthermore, they were unregulated and not sold on exchanges. That’s a risk unique to OTC derivatives.