Derivative
A derivative is a contract whose value is determined by an underlying entity (e.g. an asset, index price, interest rate, weather).
- a derivative is therefore not direct ownership in anything
- ie. the contract derives its value from the underlying.
A Billion Dollars worth of asset backed securities need to have a billion dollars of assets behind then, it's a one for one correlation. For derivatives, the same observation fails. It's said that there is well over a Quadrillion $$ of derivatives out there. In other words, even though the value of a derivative is based on something else, it's not a fixed ratio. Which is what exacerbated the CDO/CMO issue in 2008.
Purposes
- Hedge - Insure against price movements
- Speculate - Increase exposure to price movements for speculation
- Get access to otherwise difficult or impossible to obtain assets (e.g. the S&P500)
Examples
- forwards
- futures
- options
- swaps
There may also be variations of the above, such as synthetic CDOs and credit default swaps.
Synthetic CDO
- A variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals.
- Sometimes described as a bet on the performance of other mortgage (or other) products, rather than a real mortgage security.
- The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments – as in the case of a regular or "cash" CDO—but from premiums paying for credit default swap "insurance" on the possibility of default of some defined set of "reference" securities—based on cash assets.
- The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.
A Synthetic CDO is a derivative, while a traditional CDO is not.
The raw material of a traditional CDO is a mortgage. Synthetics are cheaper and easier to create than traditional CDOs when the mortgage market dries up.
Synthetic CDOs are controversial because of their role in the subprime mortgage crisis. They enabled large wagers to be made on the value of mortgage-related securities, which critics argued may have contributed to lower lending standards and fraud
- as of 2012, the notional value of synthetics was only around $2B, compared to $5T in 2006.
CDS (Credit Default Swap)
A CDS is a derivative
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