A primer on financial derivatives

By Robert O'Harrow
Washington Post Staff Writer
Wednesday, April 21, 2010

The derivative has become one of the financial world's most important risk-management tools.

Over the past two decades, derivatives have evolved from relatively straightforward deals to highly complex transactions, the outcomes of which are sometimes difficult to predict.

Some derivatives contracts are private agreements and are virtually unregulated. Others are subject to oversight and a variety of rules.

In its simplest form, a derivative is a financial agreement between two entities that depends on something that occurs in the future, such as the performance of an underlying asset. That underlying asset could be a stock, a bond, a currency or a commodity.

For example, a basic agricultural futures contract is a derivative. A farmer today might agree to sell corn to a broker next winter at a certain price. If the price goes up, the farmer misses out on greater profits. But if the price goes down, the farmer is protected from losses.

A growing variety of derivatives are designed to meet different financial needs. In a "swap," the most common form of derivative, two parties agree to exchange flows of income from different investments to manage different risk exposures in their respective portfolios.

One party in such a deal might want the potential of rising income from an investment with a floating interest rate, while the other might prefer the predictable payments ensured by a fixed interest rate. In this case, the sides agree to trade in what is known as a "plain vanilla swap."

More complex swaps can involve the performance of multiple underlying assets to hedge against risk on various fronts.

Some derivatives are agreements that amount to gambling on future events. For example, investors can place bets that the stock market, as measured by the Standard & Poor's 500-stock index, will fall or rise.

One of the most problematic derivatives in recent years is known as a "credit-default swap."

Used somewhat like insurance, credit-default swaps involve a seller of the swap, a buyer of the swap and an underlying credit asset, such as a bond or loan.

The seller of the swap receives a regular fee from the buyer in exchange for agreeing to cover losses arising from defaults on the underlying bonds or loans.

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