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Derivative security

In finance, a derivative security or derivative is a contract which
specifies the right or obligation between two parties to receive or deliver
future cash flows (or exchange of other securities or assets) based on some
future event.

Another way of defining a derivative is that it is a security whose value is
determined (derived) from one or more other securities, commodities, or
events. The value is influenced by the features of the derivative contract,
including the timing of the contract fulfillment, the value of the
underlying security or commodity, and other factors like volatility.

The payments between the parties may be determined by the future changes of:

   * the price of some other, independently traded asset in the future
     (e.g., a common stock)
   * the level of some index (e.g., a stock index or heating-degree-days)
   * the occurrence of some well specified event (e.g., a company
     defaulting)

Some derivatives are the right to buy or sell the underlying security or
commodity at some point in the future for a predetermined price. If the
price of the underlying security or commodity moves into the right
direction, the owner of the derivative makes money, otherwise they lose
money. Depending on the definition of the contract, the potential loss or
gain may be much higher than if they had traded the underlying security or
commodity directly.

Common examples of derivatives are

   * stock options,
   * interest rate swaps
   * futures
   * foreign exchange forwards or options
   * credit default swaps

Some less common, but economically intriguing examples are:

   * economic derivatives which pay off according to the state of the
     economy as measured by national statistical agencies
   * weather derivatives

Derivatives are one of the most rapidly growing and changing areas of modern
finance. According to the BIS, as of December 2002 "total estimated notional
amount of outstanding OTC contracts stood at $141.7 trillion."

The most common use of derivative securities is as a tool to buy and sell
risk. For example, a farmer may seek to sell a future in a commodity such as
wheat at a fixed price to a speculator. The farmer reduces his risk that the
price of wheat will unexpectedly raise or fall, and the speculator assumes
this risk with the possibility of a large reward.

Because derivative securities offers the possibility of large rewards, many
individuals have the strong desire to invest in derivative securities. Most
financial planners caution against this, pointing out that an investor in
derivative securities often assumes a great deal of risk and therefore
investments in derivatives must be made with caution.

Economists generally believe that derivatives have a positive impact on the
economic system by allowing the buying and selling of risk. However, many
economists are worried that derivatives may cause an economic crisis at some
point in the future. Since with a derivative security, someone loses money
while someone else gains money, under normal circumstances trading in
derivatives should not adversely affect the economic system. There is a
danger, that someone would lose so much money that they would be unable to
pay for their losses. There is a danger that this would cause a chain
reactions would would create an economic crisis. In 2002 legendary investor
Warren Buffett in an interview with the New York Times commented that he had
accumlated his wealth without the use of derivatives and that he regarded
them as 'financial weapons of mass destruction', an allusion to the phrase
'weapons of mass destruction' relating to physical weapons which had wide
currency at the time. Although there have been instances of massive losses,
most notably by Long Term Capital Management these have not have
reprecussive effects. In fact Federal Reserve Board chairman Alan Greenspan
commmented in 2003 that he believed that the use of the use of derivatives
have softened the impact of the economic downturn at beginning of the
twenty-first century.

This kind of investment gained a great deal of notoriety in 1995 when Nick
Leeson, a trader at Barings Bank, made poor and unauthorized investments in
derivatives. Through a combination of poor judgement on his part, lack of
oversight by management and unfortunate outside events, Leeson incurred a
1.3 billon dollar loss that bankrupted the centuries old financial institution.
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