Derivatives

Introduction

Forms of derivative products have existed for many years. The first derivatives

products were commodity futures contracts to establish a more certain price for

farmers’ planned production. Commodity futures have been traded through formalized

exchanges for many years. As a result of volatility in interest rates and currency

exchange agreements, certain participants in the financial markets desired to hedge

some of the risks they were facing. In the 1970s, exchange-based trading in stock

options and financial futures contracts was initiated. The birth and rapid growth of the

swap agreement began in the early 1980s.

In recent years, market deregulation, growth in global trade, and continuing

technological developments led to a corresponding increase in demand for risk

management products. This demand is reflected in the growth of financial derivatives

from the standardized futures and options products of the 1970s to the wide spectrum of

over-the-counter (OTC) products offered and sold today.

Many products and instruments are often described as derivatives by the financial press

and market participants. In this guidance, financial derivatives are broadly defined as

instruments that primarily derive their value from the performance of an underlying

asset or item, typically interest or foreign exchange rates, equity, or commodity prices.

Examples of financial derivatives include futures, swaps, options, structured debt

obligations and forward rate agreements. Recently, credit derivatives have been used

increasingly by financial institutions to mitigate potential financial difficulties

experienced as a result of the failure of borrowers to perform under the terms of loan

transactions. Some derivatives are traded on organized exchanges, whereas others are

privately negotiated transactions.

Derivatives have become an integral part of the financial markets because they can

serve several...