What are the major asset classes of derivatives?

The major asset classes of derivatives include interest rate derivatives, FX derivatives, commodity derivatives (including agricultural, energy, precious metals and other commodities), credit derivatives (including credit default swaps) and equity derivatives. 9. What is the definition of notional amount?) The notional amount of a derivative is a nominal or hypothetical amount of money upon which payment obligations are calculated (e.g., interest payments). 10. Is notional amount a useful indicator of risk? No. As stated by the Office of the Comptroller of the Currency in their most recent Quarterly Report on Trading and Derivatives Activity, The notional amount of a derivative contract is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk. 6 (Emphasis added) Similarly, the Bank for International Settlements noted that the notional amount of open positions should not be interpreted as a measu MARKET AND PRODUCT BASICS 1. What is a derivative? A derivative is a financial instrument whose value is dependent upon the change in the value of an underlying asset - such as a commodity, equity or bond or upon an event such as a change in interest rates, foreign currency exchange (FX) rates, inflation rates or the weather. The risk associated with the change in the value of the underlying asset is transferred between the parties to the derivative contract. Common examples of derivatives used in everyday business include the following:

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purchases from a foreign supplier;

gold it uses in its microprocessors; and to lock the rate on the floating rate debt it uses to finance the construction of a new building. 2. Where are derivatives traded? Some derivatives are traded on organized and regulated exchanges (exchange-traded derivatives) and some are traded privately off exchange (over-the-counter or OTC derivatives

OTC derivatives are executed over the phone and on electronic trading platforms. Some of these electronic trading platforms will be subject to regulation as so-called swap execution facilities What are OTC derivatives? OTC derivatives are derivatives that are negotiated and executed privately (i.e., bilaterally). OTC derivatives include standardized derivatives, but also customized or bespoke derivatives that are tailored to match the precise specifications of end-user customers. Collateral posting requirements have been a point of bilateral negotiation between the parties to an OTC derivative. For the most part, until passage of Dodd-Frank, OTC derivatives were not subject to regulation, although the majority of participants in the OTC derivatives market adhere to standard market practices and documentation. 4. What are exchange-traded derivatives? Exchange trading refers to the execution of standardized or plain vanilla derivative contracts on organized and regulated marketplaces called exchanges. The rules and regulations applicable to exchanges typically require that buyers and sellers are matched anonymously and that trades are centrally cleared (see below), following execution, through the exchanges clearinghouse. Examples of exchange-traded derivatives include commodity, interest rate and FX futures and options traded on the Chicago Mercantile Exchange and New York Mercantile Exchange, and equity futures and options traded

on the options exchanges in Philadelphia, New York, Chicago and San Francisco. What is central clearing? Central clearing refers to a post-trade execution process whereby an independent central counterparty (a CCP) steps in between the original counterparties to a derivative trade. As opposed to a bilateral derivative that remains in place between the two executing parties for the life of the trade, a cleared derivative is ultimately booked with a clearinghouse. Exchange-traded derivatives are always centrally cleared, but OTC derivative also can be centrally cleared. Clearinghouses are regulated and require their clearing members, and the clearing members end-user customers, to post upfront collateral at the outset (i.e., initial margin). Additional collateral (i.e., variation margin) is required on an at-least daily basis to settle the trade against its current market value, which can fluctuate substantially. A clearinghouse typically will only accept cash or other liquid collateral to be posted as margin. While central clearing is appropriate for trades that are standardized, highly liquid and easy to value (i.e., for margin calculation and settlement purposes), it is not well-suited for more customized and illiquid derivatives. Whereas the parties to a bilateral derivative are exposed to the credit risk of their counterparties (i.e., counterparty credit risk), the parties to a cleared derivative are exposed to the credit risk of the clearinghouse. Who are the different participants in the derivatives market? dy to take either side of a derivative transaction if so demanded by its customers. It is the dealers willingness and ability to buy or sell a derivative on demand that creates the market for the derivative (i.e., market making). Dealers are sometimes referred to collectively as the sell side.3 If there were no dealers, customers would have to find another party willing to take the other side of their transaction. An example that might prove useful in demonstrating the concept of dealing and market making is that of a grocer. Without the grocer, a consumer would have to go directly to the baker and the butcher to buy bread and meat. The grocer is not in the

business of baking or butchering; it buys from the baker and butcher and then sells to consumers for a profit it makes a market in food products. -dealer is an end user, including speculators and hedgers (see below); however, throughout the policy debate over the regulation of OTC derivatives, the term end user has come to mean companies that use derivatives to hedge business risk. End users are sometimes referred to collectively as the buy side. The end-user category can be broken down further into two sub-categories: hedgers and speculators.

associated with their businesses. Hedgers use derivatives to gain predictability, not to profit. Indeed, a firm that is hedging has decided to forego a potential windfall, if the underlying moves in a beneficial direction, for the certainty of fixing the price of the underlying. With a hedge, if the underlying is down, the derivative is up; if the underlying is up, the derivative is down. Virtually all types of companies, across all sizes and industry sectors, use derivatives to hedge risks associated with their businesses.

firms that frequently use derivatives for speculation include hedge funds, asset managers and proprietary trading firms. 7What are the major asset classes of derivatives? The major asset classes of derivatives include interest rate derivatives, FX derivatives, commodity derivatives (including agricultural, energy, precious metals and other commodities), credit derivatives (including credit default swaps) and equity derivatives. 9. What is the definition of notional amount?) The notional amount of a derivative is a nominal or hypothetical amount of money upon which payment obligations are calculated (e.g., interest payments).

10. Is notional amount a useful indicator of risk? No. As stated by the Office of the Comptroller of the Currency in their most recent Quarterly Report on Trading and Derivatives Activity, The notional amount of a derivative contract is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk.

(Emphasis added) Similarly, the Bank for International Settlements noted that the notional amount of open positions should not be interpreted as a measure of the counterparty risk of these positions. What types of businesses use derivatives? Businesses of all sizes and from all industry sectors use derivatives. 4. Which types of derivatives are most commonly used by end users for risk management? The most common types of derivatives used by end users are interest rate derivatives, FX forwards and commodity forwards. The interest rate swap and the FX forward are, by far, the two most common products used by non-financial end users. 13 5. Are non-financial end users frequent users of credit default swaps (CDS)? No. While there are legitimate reasons for using CDS in certain cases, it is not common for non-financial end users to enter into CDS. . Do end users hedges pose a systemic risk? It is not likely that there are many end users that pose systemic risk, especially non-financial end users. As stated previously, non-financial end users make up less than 10% of the market and the risk posed by non-financial end users is spread across tens of thousands of firms from virtually all industry sectors. Moreover, any single firm would have to enter into a very large volume of un-secured derivative trades in order to pose a threat to the financial system. AIG Financial Products is an example of a financial end user whose use of derivatives did, and may still, pose a systemic risk.
The word 'Derivative' in Financial terms is similar to the word Derivative in Mathematics. In Maths, a Derivative refers to a value or a variable that has been derived from another variable. Similarly a Financial

Derivative is something that is derived out of the market of some other market product. Hence, the Derivatives market cannot stand alone. It has to depend on a commodity or an asset from which it is derived. The price of a derivative instrument is dependent on the value of the asset from which it is derived. The underlying asset can be anything like stocks, commodities, stock indices, currencies, interest rates etc. As you know, the financial markets come with a very high degree of risk/volatility. By using the derivative products, it is possible for us to partly or fully reduce the risk and to reduce the impact of fluctuations in the asset prices. Derivatives have many categories. Derivative products can be classified into the following main types: 1. Forwards 2. Futures 3. Options 4. Swaps 5. Warrants 6. Leaps & 7. Baskets