Derivatives
Derivatives are powerful financial instruments with valuations based on the level of an underlying asset or a market index. Futures and options are commonly used forms of exchange-traded derivatives that offer tightly controlled, transparent clearing and settlement processes. However, over-the-counter (OTC) derivatives can be considerably more complex in structure. Derivatives can permit the use of leverage, meaning that users of products such as futures and options gain highly concentrated exposure to the performance of an underlying instrument, putting down a margin of as little as 10% of the face value of the underlying contract. Derivatives are therefore frequently the product of choice for speculators prepared to take on risk in return for the prospect of large gains should the underlying instrument perform as they predict. Derivatives are also used actively in hedging by those seeking to protect themselves from the risk that the underlying instrument moves in a way which is disadvantageous for them.
Legendary US investor Warren Buffett famously described derivatives as “financial weapons of mass destruction,” a view that was subsequently vindicated as ill-judged exposure to derivatives played a major role in the near collapse of institutions such as insurer AIG as the credit crunch and banking crisis reached its nadir towards the end of 2008.
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Key Concepts
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