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1.
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Definition
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Derivatives are financial instruments whose value is derived from
the value of something else. They generally take the form of
contracts under which the parties agree to payments between them
based upon the value of an underlying asset or other data at a
particular point in time. The main types of derivatives are futures,
forwards, options and swaps.
The main use of derivatives is to minimize risk for one party while
offering the potential for a high return (at increased risk) to
another. The diverse range of potential underlying assets and payoff
alternatives leads to a huge range of derivatives contracts
available to be traded in the market. Derivatives can be based on
different types of assets such as commodities, equities (stocks),
bonds, interest rates, exchange rates, or indices (such as a stock
market index, consumer price index (CPI) — see inflation derivatives
— or even an index of weather conditions, or other derivatives).
Their performance can determine both the amount and the timing of
the payoffs.
Other Resources:
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Risk Glossary:
A
derivative instrument
(or simply derivative)
is a financial instrument which derives its value from the value
of some other financial instrument or variable.
More…
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PTI Securities & Futures
L.P.:
A financial
instrument, traded on or off an exchange, the price of which is
directly dependent upon the value of one or more underlying
securities, equity indices, debt instruments, commodities, other
derivative instruments, or any agreed upon pricing index or
arrangement.
More…
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The London Bullion Market
Association:
A financial instrument derived from a cash market
commodity, futures contract or other financial instrument.
More…
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Tepper Investment Club:
A financial instrument whose value is based on the
performance of an underlying financial asset, index, or other
investment.
More…
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2.
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Examples, Types, or
Variations
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The
derivatives markets are the
financial
markets for
derivatives. The market can be divided into two, that
for
exchange
traded derivatives and that for
over-the-counter derivatives. The legal nature of
these products is very different as well as the way they are
traded, though many market participants are active in both.
Examples of
Common Derivatives:
Over-the-counter (OTC) derivatives
are contracts that are traded between two parties directly, without
going through an exchange. Products such as
swaps,
forward rate
agreements, and
exotic
options are always traded in this way. The OTC
derivatives market is huge. According to
BIS,
the total outstanding notional amount is USD 248 trillion at the end
of December 2004.
Exchange-traded derivatives are those derivatives products
that are traded via specialized Derivatives exchanges or other
exchanges. A derivatives exchange acts as an intermediary to all
related transactions, and takes Initial margin from both sides of
the trade to act as a guarantee. The world's largest[2] derivatives
exchanges (by number of transactions) are the Korea Exchange (which
lists KOSPI Index Futures & Options), Eurex (which lists a wide
range of European products such as interest rate & index products),
and CME Group (made up of the 2007 merger of the Chicago Mercantile
Exchange and the Chicago Board of Trade). According to BIS, the
combined turnover in the world's derivatives exchanges totalled USD
344 trillion during Q4 2005. Some types of derivative instruments
also may trade on traditional exchanges. For instance, hybrid
instruments such as convertible bonds and/or convertible preferred
may be listed on stock or bond exchanges. Also, warrants (or
"rights") may be listed on equity exchanges. Performance Rights,
Cash xPRTs(tm) and various other instruments that essentially
consist of a complex set of options bundled into a simple package
are routinely listed on equity exchanges. Like other derivatives,
these publicly traded derivatives provide investors access to
risk/reward and volatility characteristics that, while related to an
underlying commodity, nonetheless are distinctive.
Other Resources:
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WR Hambrecht + Co:
Three
classes of financial products fall under the heading of
derivatives: derivative securities; exchange-traded derivatives;
and over-the-counter (OTC) derivatives.
More…
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3.
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Formula
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4.
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Related Terms
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Money Market
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Bonds
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Stocks
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Foreign Exchange
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Credit
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Derivatives Market
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Equity Swap
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Credit Derivative
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Forward Contract
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Futures
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Hybrid Security
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Option
-
Rho
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5.
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As
Used in the Hedge Fund World
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Other Resources:
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Wikipedia:
Insurance
One use of derivatives is as a tool to transfer
risk.
For example, farmers can sell
futures
contracts on a crop to a speculator before the
harvest. The farmer offloads (or
hedges)
the risk that the price will rise or fall, and the speculator
accepts the risk with the possibility of a large reward. The
farmer knows for certain the revenue he will get for the crop
that he will grow; the speculator will make a profit if the
price rises, but also risks making a loss if the price falls.
It
is not unknown for farmers to walk away smiling, when they have
lost out in the derivatives market, as the result of a hedge. In
this case, they have profited from the real market from the sale
of their crops. Contrary to popular belief, financial markets
are not always a
zero-sum
game. This is an example of a situation where both parties in a
financial markets transaction benefit.
Speculation
Of course, speculators may trade with other speculators as well
as with hedgers. In most financial derivatives markets, the
value of speculative trading is far higher than the value of
true hedge trading. As well as outright speculation, derivatives
traders may also look for
arbitrage
opportunities between different derivatives on identical or
closely related underlying securities.
Other uses of derivatives are to gain an economic exposure to an
underlying security in situations where direct ownership of the
underlying is too costly or is prohibited by legal or regulatory
restrictions, or to create a synthetic
short
position.
In
addition to directional plays (i.e. simply betting on the
direction of the underlying security), speculators can use
derivatives to place bets on the
volatility of the underlying security. This technique
is commonly used when speculating with traded options.
Speculative trading in derivatives gained a great deal of
notoriety in
1995
when
Nick
Leeson, a trader at
Barings
Bank, made poor and unauthorized investments in index
futures. Through a combination of poor judgment on his part,
lack of oversight by management, a naive regulatory environment
and unfortunate outside events, Leeson incurred a 1.3
billion
dollar loss that bankrupted the centuries old financial
institution.
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6.
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Applications
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7.
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Misused
& Abused
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An
individual or a corporation should carefully weigh the risks of
using derivatives since losses can be greater than the money put
into these instruments. It should be understood that derivatives
themselves are not to be considered investments since they are not
an asset class. They simply derive their values from assets such as
bonds, equities, currencies etc. and are used to either hedge those
assets or improve the returns on those assets.
Other Resources:
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8.
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Additional Sources of Information
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Books
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News
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Scholarly Papers
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Back to Terms
| HEDGE FUND RISK AND OTHER
DISCLOSURES |
Hedge funds, including fund of funds (“Hedge
Funds”), are unregistered private investment partnerships, funds or
pools that may invest and trade in many different markets,
strategies and instruments (including securities, non-securities and
derivatives) and are NOT subject to the same regulatory requirements
as mutual funds, including mutual fund requirements to provide
certain periodic and standardized pricing and valuation information
to investors. There are substantial risks in investing in Hedge
Funds. Persons interested in investing in Hedge Funds should
carefully note the following:
- Hedge Funds represent speculative investments and involve a
high degree of risk. An investor could lose all or a substantial
portion of his/her investment. Investors must have the financial
ability, sophistication/experience and willingness to bear the
risks of an investment in a Hedge Fund.
- An investment in a Hedge Fund should be discretionary capital
set aside strictly for speculative purposes.
- An investment in a Hedge Fund is not suitable or desirable for
all investors. Only qualified eligible investors may invest in
Hedge Funds.
- Hedge Fund offering documents are not reviewed or approved by
federal or state regulators
- Hedge Funds may be leveraged (including highly leveraged) and
a Hedge Fund’s performance may be volatile
- An investment in a Hedge Fund may be illiquid and there may be
significant restrictions on transferring interests in a Hedge
Fund. There is no secondary market for an investor’s investment in
a Hedge Fund and none is expected to develop.
- A Hedge Fund may have little or no operating history or
performance and may use hypothetical or pro forma performance
which may not reflect actual trading done by the manager or
advisor and should be reviewed carefully. Investors should not
place undue reliance on hypothetical or pro forma performance.
- A Hedge Fund’s manager or advisor has total trading authority
over the Hedge Fund.
- A Hedge Fund may use a single advisor or employ a single
strategy, which could mean a lack of diversification and higher
risk.
- A Hedge Fund (for example, a fund of funds) and its managers
or advisors may rely on the trading expertise and experience of
third-party managers or advisors, the identity of which may not be
disclosed to investors
- A Hedge Fund may involve a complex tax structure, which should
be reviewed carefully.
- A Hedge Fund may involve structures or strategies that may
cause delays in important tax information being sent to investors.
- A Hedge Fund may provide no transparency regarding its
underlying investments (including sub-funds in a fund of funds
structure) to investors. If this is the case, there will be no way
for an investor to monitor the specific investments made by the
Hedge Fund or, in a fund of funds structure, to know whether the
sub-fund investments are consistent with the Hedge Fund’s
investment strategy or risk levels.
- A Hedge Fund may execute a substantial portion of trades on
foreign exchanges or over-the-counter markets, which could mean
higher risk.
- A Hedge Fund’s fees and expenses-which may be substantial
regardless of any positive return- will offset the Hedge Fund’s
trading profits. In a fund of funds or similar structure, fees are
generally charged at the fund as well as the sub-fund levels;
therefore fees charged investors will be higher that those charged
if the investor invested directly in the sub-fund(s).
- Hedge Funds are not required to provide periodic pricing or
valuation information to investors.
- Hedge Funds and their managers/advisors may be subject to
various conflicts of interest.
The above general
summary is not a complete list of the risks and other important
disclosures involved in investing in Hedge Funds and, with respect
to any particular Hedge Fund, is subject to the more complete and
specific disclosures contained in such Hedge Fund’s respective
offering documents. Before making any investment, an investor should
thoroughly review a Hedge Fund’s offering documents with the
investor’s financial, legal and tax advisor to determine whether an
investment in the Hedge Fund is suitable for the investor in light
of the investor’s investment objectives, financial circumstances and
tax situation.
All performance information is believed
to be net of applicable fees unless otherwise specifically noted. No
representation is made that any fund will or is likely to achieve
its objectives or that any investor will or is likely to achieve
results comparable to those shown or will make any profit at all or
will be able to avoid incurring substantial losses. Past performance
is not necessarily indicative, and is no guarantee, of future
results.
The information on the Site is intended for
informational, educational and research purposes only. Nothing on
this Site is intended to be, nor should it be construed or used as,
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appropriateness or suitability of an investment, or intended to be
an offer, or the solicitation of any offer, to buy or sell any
security or an endorsement or inducement to invest with any fund or
fund manager. No such offer or solicitation may be made prior to the
delivery of appropriate offering documents to qualified investors.
Before making any investment, you should thoroughly review the
particular fund’s confidential offering documents with your
financial, legal and tax advisor and conduct such due diligence as
you (and they) deem appropriate. We do not provide investment advice
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The information on this Site is as of the date(s) indicated,
is not a complete description of any fund, and is subject to the
more complete disclosures and terms and conditions contained in a
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returns, valuations, fund targets and strategies, has been supplied
by the funds or their agents, and other third parties, and although
believed to be reliable, has not been independently verified and its
completeness and accuracy cannot be guaranteed. No warranty, express
or implied, representation or guarantee is made as to the accuracy,
validity, timeliness, completeness or suitability of this
information.
Any indices and other financial benchmarks
shown are provided for illustrative purposes only, are unmanaged,
reflect reinvestment of income and dividends and do not reflect the
impact of advisory fees. Investors cannot invest directly in an
index. Comparisons to indexes have limitations because indexes have
volatility and other material characteristics that may differ from a
particular hedge fund. For example, a hedge fund may typically hold
substantially fewer securities than are contained in an index.
Indices also may contain securities or types of securities that are
not comparable to those traded by a hedge fund. Therefore, a hedge
fund’s performance may differ substantially from the performance of
an index. Because of these differences, indexes should not be relied
upon as an accurate measure of comparison.
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