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Derivative (finance) 1
Futures contract 9
Forward contract 19
Option (finance) 25
Call option 35
Put option 38
Strike price 40
Swap (finance) 42
Interest rate derivative 46
Foreign exchange derivative 49
Credit derivative 49
Equity derivative 54
Warrant (finance) 56
Foreign exchange option 63
Gold as an investment 65
Credit default swap 75
Equity swap 99
Property derivatives 101
Freight derivative 104
Inflation derivative 105

Article Sources and Contributors 107
Image Sources, Licenses and Contributors 109

Article Licenses
License 110
Derivative (finance) 1

Derivative (finance)
In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a
value, based on the expected future price movements of the asset to which it is linked—called the underlying
asset—[1] such as a share or a currency. There are many kinds of derivatives, with the most common being swaps,
futures, and options. Derivatives are a form of alternative investment.
A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of derivatives
have been traded on markets before their expiration date as if they were assets. Among the oldest of these are
rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[2]
Derivatives are usually broadly categorized by:
• the relationship between the underlying asset and the derivative (e.g., forward, option, swap);
• the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives,
commodity derivatives or credit derivatives);
• the market in which they trade (e.g., exchange-traded or over-the-counter);
• their pay-off profile.
Another arbitrary distinction is between:[3]
• vanilla derivatives (simple and more common); and
• exotic derivatives (more complicated and specialized).

Derivatives are used by investors to:
• provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in
the value of the derivative;
• speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given
direction, stays in or out of a specified range, reaches a certain level);
• hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite
direction to their underlying position and cancels part or all of it out;
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
• create option ability where the value of the derivative is linked to a specific condition or event (e.g., the
underlying reaching a specific price level).

Derivatives can be considered as providing a form of insurance in hedging, which is itself a technique that attempts
to reduce risk.
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For
example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a
specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty
of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be
available because of events unspecified by the contract, such as the weather, or that one party will renege on the
contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured
against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures
contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and
acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional
Derivative (finance) 2

income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall
below the price specified in the contract (thereby paying more in the future than he otherwise would have) and
reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is
the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon
payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution
has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according
to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while
reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the
future value of the asset.
Derivatives can serve legitimate business purposes. For
example, a corporation borrows a large sum of money
at a specific interest rate.[4] The rate of interest on the
loan resets every six months. The corporation is
concerned that the rate of interest may be much higher
in six months. The corporation could buy a forward rate
agreement (FRA), which is a contract to pay a fixed
rate of interest six months after purchases on a notional
amount of money.[5] If the interest rate after six months
is above the contract rate, the seller will pay the
difference to the corporation, or FRA buyer. If the rate
is lower, the corporation will pay the difference to the
Derivatives traders at the Chicago Board of Trade.
seller. The purchase of the FRA serves to reduce the
uncertainty concerning the rate increase and stabilize

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and
institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the
party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset
in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset
in the future at a high price according to a derivative contract when the future market price is low.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset
falls below the price specified in a futures contract to sell the asset.
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 futures contracts. Through a combination of poor judgment, lack
of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson
incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[6]
Derivative (finance) 3

Types of derivatives

OTC and exchange-traded

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in
the market:
• Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between
two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate
agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest
market for derivatives, and is largely unregulated with respect to disclosure of information between the parties,
since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting
of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange.
According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as
of June 2008).[7] Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS),
9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other.
Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are
subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.
• Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.[8] 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[9] 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 and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover
in the world's derivatives exchanges totaled 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 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.

Common derivative contract types

There are three major classes of derivatives:
1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A
futures contract differs from a forward contract in that the futures contract is a standardized contract written by a
clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is
a non-standardized contract written by the parties themselves.
2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or
sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and
is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the
case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity
date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity
date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the
Derivative (finance) 4

3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value
of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.
More complex derivatives can be created by combining the elements of these basic types. For example, the holder of
a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

The overall derivatives market has five major classes of underlying asset:
• interest rate derivatives (the largest)
• foreign exchange derivatives
• credit derivatives
• equity derivatives
• commodity derivatives
Some common examples of these derivatives are:


Exchange-traded Exchange-traded OTC swap OTC forward OTC option

futures options

Equity DJIA Index future Option on DJIA Index Equity swap Back-to-back Stock option
Single-stock future future Repurchase agreement Warrant
Single-share option Turbo warrant

Interest rate Eurodollar future Option on Eurodollar Interest rate swap Forward rate agreement Interest rate cap and
Euribor future future floor
Option on Euribor future Swaption
Basis swap
Bond option

Credit Bond future Option on Bond future Credit default Repurchase agreement Credit default option
Total return swap

Foreign exchange Currency future Option on currency future Currency swap Currency forward Currency option

Commodity WTI crude oil futures Weather derivatives Commodity swap Iron ore forward Gold option

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives
• Economic derivatives that pay off according to economic reports[10] as measured and reported by national
statistical agencies
• Freight derivatives
• Inflation derivatives
• Weather derivatives
• Insurance derivatives
• Emissions derivatives[11]
Derivative (finance) 5


Market and arbitrage-free

Two common measures of value are:
• Market price, i.e., the price at which
traders are willing to buy or sell the
• Arbitrage-free price, meaning that
no risk-free profits can be made by
trading in these contracts; see
rational pricing.

Determining the market price Total world derivatives from 1998-2007

compared to total world wealth in the year
For exchange-traded derivatives,
market price is usually transparent
(often published in real time by the exchange, based on all the current bids and offers placed on that particular
contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled
manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central
exchange to collate and disseminate prices.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider.
Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the
underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black–Scholes
formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a
continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the
binomial options model. OTC represents the biggest challenge in using models to price derivatives. Since these
contracts are not publicly traded, no market price is available to validate the theoretical valuation. And most of the
model's results are input-dependant (meaning the final price depends heavily on how we derive the pricing
inputs).[14] Therefore it is common that OTC derivatives are priced by Independent Agents that both counterparties
involved in the deal designate upfront (when signing the contract).

Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow
investors to earn large returns from small movements in the underlying asset's price. However, investors could lose
large amounts if the price of the underlying moves against them significantly. There have been several instances of
massive losses in derivative markets, such as:
• The need to recapitalize insurer American International Group (AIG) with US$85 billion of debt provided by
the US federal government.[15] An AIG subsidiary had lost more than US$18 billion over the preceding three
quarters on Credit Default Swaps (CDS) it had written.[16] It was reported that the recapitalization was
Derivative (finance) 6

necessary because further losses were foreseeable over the next few quarters.
• The loss of US$7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.
• The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September
2006 when the price plummeted.
• The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
• The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.[17]
• The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[18]

Counter-party risk
Some derivatives (especially swaps) expose investors to counter-party risk.
For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer
variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate
for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business
will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the
first business may be adversely affected, because it may not be prepared to pay the higher variable rate.
Different types of derivatives have different levels of counter-party risk. For example, standardized stock options by
law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any
losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties.
However, in private agreements between two companies, for example, there may not be benchmarks for performing
due diligence and risk analysis.

Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses
that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing
in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual
report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control
an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities
markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what
was originally meant to be a market to transfer risk now becomes a leading indicator. (See Berkshire Hathaway
Annual Report for 2002) [19]

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real
economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or
even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to
February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression. (See
Berkshire Hathaway Annual Report for 2002)

The use of derivatives also has its benefits:
• Derivatives facilitate the buying and selling of risk, and many people consider this to have a positive impact on
the economic system. Although someone loses money while someone else gains money with a derivative, under
normal circumstances, trading in derivatives should not adversely affect the economic system because it is not
zero sum in utility.
Derivative (finance) 7

• Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of
derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Government regulation
In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman
of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the
derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks
in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into
derivatives, too. The department’s antitrust unit is actively investigating 'the possibility of anticompetitive practices
in the credit derivatives clearing, trading and information services industries,' according to a department

• Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal
obligation covering all included individual contracts. This means that a bank’s obligation, in the event of the
default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of
contracts included in the bilateral netting arrangement.
• Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit
derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps.
• Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency
exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including
structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various
combinations thereof.
• Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and options) that
are transacted on an organized futures exchange.
• Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its
counter-parties, without taking into account netting. This represents the maximum losses the bank’s
counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was
held by the counter-parties.
• Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its
counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all
its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral.
• High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest
rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities.
• Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk
management products. This amount generally does not change hands and is thus referred to as notional.
• Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off
organized futures exchanges.
• Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more
indices and / or have embedded forwards or options.
• Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders
equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority
interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt,
intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a bank’s allowance
for loan and lease losses.
Derivative (finance) 8

[1] McDonald, R.L. (2006) Derivatives markets. Boston: Addison-Wesley
[2] Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan" (http:/ / www. ft.
com/ cms/ s/ 0/ d9f45d80-6922-11da-bd30-0000779e2340. html). The Financial Times. . Retrieved October 23, 2010.
[3] Taylor, Francesca. (2007). Mastering Derivatives Markets. Prentice Hall
[4] Chisolm, Derivatives Demystified (Wiley 2004)
[5] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.
[6] News.BBC.co.uk (http:/ / news. bbc. co. uk/ 2/ hi/ business/ 375259. stm), "How Leeson broke the bank - BBC Economy"
[7] BIS survey: The Bank for International Settlements (BIS) semi-annual OTC derivatives statistics (http:/ / www. bis. org/ statistics/ derstats.
htm) report, for end of June 2008, shows US$683.7 billion total notional amounts outstanding of OTC derivatives with a gross market value of
US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics (http:/ / www. bis. org/ publ/ otc_hy0805. htm).
[8] Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009
[9] Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website (http:/ / www. fow. com).
[10] "Biz.Yahoo.com" (http:/ / biz. yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retrieved 2010-08-29.
[11] FOW.com (http:/ / www. fow. com/ Article/ 1385702/ Issue/ 26557/ Emissions-derivatives-1. html), Emissions derivatives, 1 December
[12] "Bis.org" (http:/ / www. bis. org/ statistics/ derstats. htm). Bis.org. 2010-05-07. . Retrieved 2010-08-29.
[13] "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006" (http:/ / www. wider. unu. edu/ events/
past-events/ 2006-events/ en_GB/ 05-12-2006/ ). . Retrieved 9 June 2009.
[14] Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-2009. http:/ / www. hedgefundsreview. com/
hedge-funds-review/ news/ 1560286/ otc-pricing-deal-struck-fitch-solutions-pricing-partners
[15] Derivatives Counter-party Risk: Lessons from AIG and the Credit Crisis (http:/ / www. compoundinghappens. com/ opinion/
DerivativesCounterPartyRisk. htm)
[16] Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters" (http:/ / www. reuters.
com/ article/ newsOne/ idUSN1837154020080918). Reuters.com. . Retrieved 2010-08-29.
[17] Edwards, Franklin (1995), "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft" (http:/ / www0. gsb. columbia.
edu/ faculty/ fedwards/ papers/ DerivativesCanBeHazardous. pdf), Derivatives Quarterly (Spring 1995): 8–17,
[18] Whaley, Robert (2006). Derivatives: markets, valuation, and risk management (http:/ / books. google. com/ books?id=Hb7xXy-wqiYC&
printsec=frontcover& source=gbs_ge_summary_r& cad=0#v=onepage& q& f=false). John Wiley and Sons. p. 506. ISBN 0471786322. .
[19] http:/ / www. berkshirehathaway. com/ 2002ar/ 2002ar. pdf
[20] Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives" (http:/ / www. nytimes. com/ 2010/ 12/ 12/ business/ 12advantage.
html?hp), The New York Times, December 11, 2010 (December 12, 2010 p. A1 NY ed.). Retrieved 2010-12-12.

Further reading
• Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A Handbook of
Structuring, Pricing & Investor Applications (Financial Times) Amazon listing (http://www.amazon.com/

External links
• BBC News - Derivatives simple guide (http://news.bbc.co.uk/1/hi/business/2190776.stm)
• European Union proposals on derivatives regulation - 2008 onwards (http://ec.europa.eu/internal_market/
• Derivatives in Africa (http://www.mfw4a.org/capital-markets/derivatives-derivatives-exchanges-commodities.
Futures contract 9

Futures contract
In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset (e.g.
oranges, oil, gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures
price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds,
rights or warrants. They are still securities, however, though they are a type of derivative contract. The party
agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in
the future assumes a short position.
The price is determined by the instantaneous equilibrium between the forces of supply and demand among
competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.
In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all – that is, for
financial futures, the underlying asset or item can be currencies, securities or financial instruments and intangible
assets or referenced items such as stock indexes and interest rates.
The future date is called the delivery date or final settlement date. The official price of the futures contract at the end
of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.[1]
A closely related contract is a forward contract; they differ in certain respects. Futures contracts are very similar to
forward contracts, except they are exchange-traded and defined on standardized assets.[2] Unlike forwards, futures
typically have interim partial settlements or "true-ups" in margin requirements. For typical forwards, the net gain or
loss accrued over the life of the contract is realized on the delivery date.
A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas
an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the
option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures
contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it
is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who
made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset
his/her position by either selling a long position or buying back (covering) a short position, effectively closing out
the futures position and its contract obligations.
Futures contracts, or simply futures, (but not future or future contract) are exchange-traded derivatives. The
exchange's clearing house acts as counterparty on all contracts, sets margin requirements, and crucially also provides
a mechanism for settlement.[3]

Aristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial device, which
involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest
would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive press
owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was
ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the
harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of
a poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he let them out
at any rate he pleased, and made a large quantity of money.[4]
The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the needs of samurai
who—being paid in rice, and after a series of bad harvests—needed a stable conversion to coin.[5]
The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864,
which were called futures contracts. This contract was based on grain trading and started a trend that saw contracts
created on a number of different commodities as well as a number of futures exchanges set up in countries around
Futures contract 10

the world.[6] By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded
to futures on edible oilseeds complex, raw jute and jute goods and bullion.[7]

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed
number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term
interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of
physical commodities, this specifies not only the quality of the underlying goods but also the manner and location
of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content
and API specific gravity, as well as the pricing point -- the location where delivery must be made.
• The delivery month.
• The last trading date.
• Other details such as the commodity tick, the minimum permissible price fluctuation.

To minimize credit risk to the exchange, traders must
post a margin or a performance bond, typically
5%-15% of the contract's value.
To minimize counterparty risk to traders, trades
executed on regulated futures exchanges are
guaranteed by a clearing house. The clearing house
becomes the buyer to each seller, and the seller to
each buyer, so that in the event of a counterparty
default the clearer assumes the risk of loss. This
enables traders to transact without performing due
diligence on their counterparty.

Margin requirements are waived or reduced in some

cases for hedgers who have physical ownership of
the covered commodity or spread traders who have
offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure
that companies or corporations perform on their
customers' open futures and options contracts.
Clearing margins are distinct from customer margins
that individual buyers and sellers of futures and
options contracts are required to deposit with

Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures
contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission
Futures contract 11

Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market
risk and contract value. Also referred to as performance bond margin.
Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum
exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated
based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to
restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is
usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to
close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is
liable for any resulting deficit in the client’s account.
Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the
initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial
margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin
(which is set by the Federal Reserve in the U.S. Markets).
A futures account is marked to market daily. If the margin drops below the margin maintenance requirement
established by the exchange listing the futures, a margin call will be issued to bring the account back up to the
required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his
margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held
as margin at any particular time. The low margin requirements of futures results in substantial leverage of the
investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader.
The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he
does not want to be subject to margin calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an
options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or
down payment on the commodity itself, but rather it is a security deposit.
Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the
exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin).
The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two
months, that would be about 77% annualized.

Settlement - physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of
futures contract:
• Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the
contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with
commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by
purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling
a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method
Futures contract 12

of settlement upon expiration

• Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest
rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the
loss/gain related to the contract in cash when the contract expires.[8] Cash settled futures are those that, as a
practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A
futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures
use this method.
Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops
trading, as well as the final settlement price for that contract. For many equity index and interest rate futures
contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On this day
the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the
expiration of the December contract, the March futures become the nearest contract. This is an exciting time for
arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the
underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the
underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded
by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next
contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against
current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see
positions expire in as many as eight major markets almost every half an hour.

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is
determined via arbitrage arguments. This is typical for stock index futures, treasury bond futures, and futures on
physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the
deliverable commodity is not in plentiful supply or when it does not yet exist - for example on crops before the
harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be
created upon the delivery date) - the futures price cannot be fixed by arbitrage. In this scenario there is only one force
setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand
for the futures contract.

Arbitrage arguments
Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or may be freely
created. Here, the forward price represents the expected future value of the underlying discounted at the risk free
rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be
arbitraged away.
Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding
the present value S(t) at time t to maturity T by the rate of risk-free return r.

or, with continuous compounding

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.
In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice
there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on
short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries
around the theoretical price.
Futures contract 13

Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be
applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's supply
and demand for the underlying asset in the futures.
In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an
unbiased expectation of the future price of the actual asset and so be given by the simple relationship.
By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have
been deliberately withheld from market participants (an illegal action known as cornering the market), the market
clearing price for the futures may still represent the balance between supply and demand but the relationship between
this price and the expected future price of the asset can break down.

Relationship between arbitrage arguments and expectation

The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to
the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability.
With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable

Contango and backwardation

The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future
delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a
commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer
future delivery, is known as backwardation.

Futures contracts and exchanges

There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about
which the contract may be based such as commodities, securities (such as single-stock futures), currencies or
intangibles such as interest rates and indexes. For information on futures markets in specific underlying commodity
markets, follow the links. For a list of tradable commodities futures contracts, see List of traded commodities. See
also the futures exchange article.
• Foreign exchange market
• Money market
• Bond market
• Equity market
• Soft Commodities market
Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland
with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a
marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also
called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers
and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began
with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals,
energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest
Futures contract 14

Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and
these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume
and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges
worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche
Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures
and futures options exchanges worldwide trading to include: [9]
• CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including US Bonds);
Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow Jones Industrial
Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc.)
• IntercontinentalExchange (ICE Futures Europe) - formerly the International Petroleum Exchange trades energy
including crude oil, heating oil, natural gas and unleaded gas
• NYSE Euronext - which absorbed Euronext into which London International Financial Futures and Options
Exchange or LIFFE (pronounced 'LIFE') was merged. (LIFFE had taken over London Commodities Exchange
("LCE") in 1996)- softs: grains and meats. Inactive market in Baltic Exchange shipping. Index futures include
EURIBOR, FTSE 100, CAC 40, AEX index.
• South African Futures Exchange - SAFEX
• Sydney Futures Exchange
• Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)
• Tokyo Commodity Exchange TOCOM
• Tokyo Financial Exchange [10] - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate
• Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures)
• London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel, tin and steel
• IntercontinentalExchange (ICE Futures U.S.) - formerly New York Board of Trade - softs: cocoa, coffee, cotton,
orange juice, sugar
• New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil, natural gas,
coal, propane, gold, silver, platinum, copper, aluminum and palladium
• Dubai Mercantile Exchange
• Korea Exchange - KRX
• Singapore Exchange - SGX - into which merged Singapore International Monetary Exchange (SIMEX)
• ROFEX - Rosario (Argentina) Futures Exchange

Most Futures contracts codes are four characters. The first two characters identify the contract type, the third
character identifies the month and the last character is the last digit of the year.
Third (month) futures contract codes are
• January = F
• February = G
• March = H
• April = J
• May = K
• June = M
• July = N
• August = Q
• September = U
Futures contract 15

• October = V
• November = X
• December = Z
Example: CLX0 is a Crude Oil (CL), November (X) 2010 (0) contract.

Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset
(which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price
changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract
related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the
underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect
via a short futures contract.
Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to
certain influences such as an interest rate.
For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they
produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase
futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets,
"producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to
reduce or remove the risk on the swap.
An example that has both hedge and speculative notions involves a mutual fund or separately managed account
whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The
Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long)
S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or
account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks
just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in
the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible
(an efficient amount of shares of every individual position within the fund or account can be purchased), the
portfolio manager can close the contract and make purchases of each individual stock.
The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between
traders with different risk and time preferences, from a hedger to a speculator, for example.

Options on futures
In many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a
futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified
futures price at which the future is traded if the option is exercised. See the Black-Scholes model, which is the most
popular method for pricing these option contracts. Futures are often used since they are delta one instruments.

Futures contract regulations

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC),
an independent agency of the United States government. The Commission has the right to hand out fines and other
punishments for an individual or company who breaks any rules. Although by law the commission regulates all
transactions, each exchange can have its own rule, and under contract can fine companies for different things or
extend the fine that the CFTC hands out.
Futures contract 16

The CFTC publishes weekly reports containing details of the open interest of market participants for each
market-segment that has more than 20 participants. These reports are released every Friday (including data from the
previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as
commercial and non-commercial open interest. This type of report is referred to as the 'Commitments of Traders
Report', COT-Report or simply COTR.

Definition of futures contract

Following Björk[11] we give a definition of a futures contract. We describe a futures contract with delivery of item J
at the time T:
• There exists in the market a quoted price F(t,T), which is known as the futures price at time t for delivery of J at
time T.
• At time T, the holder pays F(T,T) and is entitled to receive J.
• During any time interval , the holder receives the amount .
• The spot price of obtaining the futures contract is equal to zero, for all time t such that .

Some exchanges tolerate 'nonconvergence', the failure of futures contracts and the value of the physical commodities
they represent to reach the same value on 'contract settlement' day at the designated delivery points. An example of
this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures. SRW futures have settled more
than 20¢ apart on settlement day and as much as $1.00 difference between settlement days. Only a few participants
holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to
settle futures contracts. Therefore, it's impossible for almost any individual producer to 'hedge' efficiently when
relying on the final settlement of a futures contract for SRW. The trend is for the CBOT to continue to restrict those
entities that can actually participate in settling commodities contracts to those that can ship or receive large quantities
of railroad cars and multiple barges at a few selected sites. The Commodity Futures Trading Commission, which has
oversight of the futures market in the United States, has made no comment as to why this trend is allowed to
continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the
underlying commodity they represent is the basis of integrity for a futures market. It follows that the function of
'price discovery', the ability of the markets to discern the appropriate value of a commodity reflecting current
conditions, is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with
the commodities they represent.[12]

Futures versus forwards

While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they
are different in two main respects:
• Futures are exchange-traded, while forwards are traded over-the-counter.
Thus futures are standardized and face an exchange, while forwards are customized and face a non-exchange
• Futures are margined, while forwards are not.
Thus futures have significantly less credit risk, and have different funding.
Futures contract 17

Exchange versus OTC

Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a
signed contract between two parties.
• Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter.
• In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty
for delivery on a futures contract is chosen by the clearing house.

Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and
underlying asset (based on mark to market).
Forwards do not have a standard. They may transact only on the settlement date. More typical would be for the
parties to agree to true up, for example, every quarter. The fact that forwards are not margined daily means that, due
to movements in the price of the underlying asset, a large differential can build up between the forward's delivery
price and the settlement price, and in any event, an unrealized gain (loss) can build up.
Again, this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future
to the collateral securing the contract to keep it in line with the brokerage margin requirements. This true-ing up
occurs by the "loss" party providing additional collateral; so if the buyer of the contract incurs a drop in value, the
shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the
brokerage account.
In a forward though, the spread in exchange rates is not trued up regularly but, rather, it builds up as unrealized gain
(loss) depending on which side of the trade being discussed. This means that entire unrealized gain (loss) becomes
realized at the time of delivery (or as what typically occurs, the time the contract is closed prior to expiration) -
assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery.
The result is that forwards have higher credit risk than futures, and that funding is charged differently.
In most cases involving institutional investors, the daily variation margin settlement guidelines for futures call for
actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash.
The threshold amount for daily futures variation margin for institutional investors is often $1,000.
The situation for forwards, however, where no daily true-up takes place in turn creates credit risk for forwards, but
not so much for futures. Simply put, the risk of a forward contract is that the supplier will be unable to deliver the
referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening
party closes the contract.
The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an
equivalent forward purchased that day. This means that there will usually be very little additional money due on the
final day to settle the futures contract: only the final day's gain or loss, not the gain or loss over the life of the
In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further
limiting credit risk in futures.
Example: Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100
delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This
means that the "mark-to-market" calculation would require the holder of one side of the future to pay $2 on day 51 to
track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of
the other side of the future. That is, the loss party wires cash to the other party.
Futures contract 18

A forward-holder, however, may pay nothing until settlement on the final day, potentially building up a large
balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects of convexity
bias (due to earning or paying interest on margin), futures and forwards with equal delivery prices result in the same
total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily
price changes, while the forward's spot price converges to the settlement price. Thus, while under mark to market
accounting, for both assets the gain or loss accrues over the holding period; for a futures this gain or loss is realized
daily, while for a forward contract the gain or loss remains unrealized until expiry.
Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European derivative:
the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path
of prices on the way. This difference is generally quite small though.
With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk of
counterparty default. The only risk is that the clearing house defaults (e.g. become bankrupt), which is considered
very unlikely.

[1] Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http:/ / www. pearsonschool. com/ index.
cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). Upper
Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 288. ISBN 0-13-063085-3.
[2] Forward Contract on Wikinvest
[3] Hull, John C. (2005). Options, Futures and Other Derivatives (excerpt by Fan Zhang) (http:/ / fan. zhang. gl/ ecref/ futures) (6th ed.).
Prentice-Hall. ISBN 0-13-149908-4.
[4] Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The Great Books of the Western World, book 1, chap. 11, p. 453.
[5] Schaede, Ulrike (September 1989). "Forwards and futures in tokugawa-period Japan:A new perspective on the Djima rice market". Journal of
Banking & Finance 13 (4-5): 487–513. doi:10.1016/0378-4266(89)90028-9
[6] "timeline-of-achievements" (http:/ / www. cmegroup. com/ company/ history/ timeline-of-achievements. html). CME Group. . Retrieved
August 5, 2010.
[7] Inter-Ministerial task force (chaired by Wajahat Habibullah) (May 2003). "Convergence of Securities and Commodity Markets report" (http:/
/ www. fmc. gov. in/ htmldocs/ reports/ rep03. htm). Forward Markets Commission (India). . Retrieved August 5, 2010.
[8] Cash settlement on Wikinvest
[9] Futures & Options Factbook (http:/ / www. theIFM. org/ gfb). Institute for Financial Markets.
[10] http:/ / www. tfx. co. jp/ en/
[11] Björk: Arbitrage theory in continuous time, Cambridge university press, 2004
[12] Henriques, D Mysterious discrepancies in grain prices baffle experts (http:/ / www. iht. com/ articles/ 2008/ 03/ 27/ business/ commod. php),
International Herald Tribune, March 23, 2008. Accessed April 12, 2008

• The Institute for Financial Markets (http://www.theifm.org) (2003). Futures & Options (http://www.theifm.
org/index.cfm?inc=education/focourse.inc). Washington, DC: The IFM. p. 237.
• Redhead, Keith (1997). Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps.
London: Prentice-Hall. ISBN 013241399X.
• Lioui, Abraham; Poncet, Patrice (2005). Dynamic Asset Allocation with Forwards and Futures. New York:
Springer. ISBN 0387241078.
• Valdez, Steven (2000). An Introduction To Global Financial Markets (3rd ed.). Basingstoke, Hampshire:
Macmillan Press. ISBN 0333764471.
• Arditti, Fred D. (1996). Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and
Mortgage Securities. Boston: Harvard Business School Press. ISBN 0875845606.
• The Institute for Financial Markets' Futures & Options Factbook (http://www.theifm.org/gfb)
Futures contract 19

U.S. Futures exchanges and regulators

• Chicago Board of Trade, now part of CME Group
• Chicago Mercantile Exchange, now part of CME Group
• Commodity Futures Trading Commission
• National Futures Association
• Kansas City Board of Trade
• New York Board of Trade now ICE
• New York Mercantile Exchange, now part of CME Group
• Minneapolis Grain Exchange

External links
• BBC Oil Futures Investigation (http://news.bbc.co.uk/1/hi/magazine/7559032.stm)
• CME Group futures contracts product codes (http://www.cmegroup.com/product-codes-listing/)
'Bold text

Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or
sell an asset at a specified future time at a price agreed today.[1] This is in contrast to a spot contract, which is an
agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the
underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a
short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the
contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is
one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are
The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset
changes hands on the spot date. The difference between the spot and the forward price is the forward premium or
forward discount, generally considered in the form of a profit, or loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a
means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is
A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to
futures contracts, except they are not exchange-traded, or defined on standardized assets.[2] Forwards also typically
have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not
exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the
contract is open. However, being traded OTC, forward contracts specification can be customized and may include
mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge
collateral or additional collateral to better secure the party at gain.
Forward contract 20

The value of a forward position at maturity depends on the relationship between the delivery price ( ) and the
underlying price ( ) at that time.
• For a long position this payoff is:
• For a short position, it is:

How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a
$100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each
other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale
price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the
underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract.
At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy
is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only
to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has
made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000.
The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a
currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to
exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars
fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one
party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is
opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is
denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian
dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the
exchange rate to move favorably to generate a gain on closing the contract.
In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian
dollars equivalent to, say $114.4 million USD at the current rate—these two amounts are called the notional
amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement
to command or open such a contract is considerably less than that amount, which refers to the leverage created,
Forward contract 21

which is typical in derivative contracts.

Example of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters
into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for
$100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk
free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk
free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him - the
opportunity cost will be covered.

Spot - forward parity

Spot-forward parity provides the link between the spot market and the forward market. It describes the relationship
between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be
described as the cost of carry, this effect can be broken down into different components, specifically whether the
• pays income, and if so whether this is on a discrete or continuous basis
• incurs storage costs
• is regarded as
• an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities);
• or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.)

Investment assets
For an asset that provides no income, the relationship between the current forward ( ) and spot ( ) prices is

where is the continuously compounded risk free rate of return, and is the time to maturity. The intuition behind
this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market
between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both
approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational
pricing below.
For an asset that pays known income, the relationship becomes:
• Discrete:
• Continuous:
where is the present value of the discrete income at time , and is the continuous
dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to
holding the asset rather than the forward because you get to receive this income. Hence the income ( or ) must
be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and
example of an asset which pays a continuous yield might be a foreign currency or a stock index.
For investment assets which are commodities, such as gold and silver, storage costs must also be considered.
Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage
costs, the relationship becomes:
• Discrete:
• Continuous:
where is the present value of the discrete storage cost at time , and is the storage
cost where it is proportional to the price of the commodity, and is hence a 'negative yield'. The intuition here is that
Forward contract 22

because storage costs make the final price higher, we have to add them to the spot price.

Consumption assets
Consumption assets are typically raw material commodities which are used as a source of energy or in a production
process, for example crude oil or iron ore. Users of these consumption commodities may feel that there is a benefit
from physically holding the asset in inventory as opposed to holding a forward on the asset. These benefits include
the ability to profit from temporary shortages and the ability to keep a production process running,[1] and are referred
to as the convenience yield. Thus, for consumption assets, the spot-forward relationship is:

• Discrete storage costs:

• Continuous storage costs:
where is the convenience yield over the life of the contract. Since the convenience yield provides a benefit
to the holder of the asset but not the holder of the forward, it can be modelled as a type of 'dividend yield'. However,
it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations
concerning future availability of the commodity. If users have low inventories of the commodity, this implies a
greater chance of shortage, which means a higher convenience yield. The opposite is true when high inventories

Cost of carry
The relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that
asset relative to holding the forward. Thus, all of the costs and benefits above can be summarised as the cost of
carry, . Hence,

• Discrete:
• Continuous: , where .

Relationship between the forward price and the expected future spot price
The market's opinion about what the
spot price of an asset will be in the
future is the expected future spot
price.[1] Hence, a key question is
whether or not the current forward
price actually predicts the respective
spot price in the future. There are a
number of different hypotheses which
try to explain the relationship between
the current forward price, and the
expected future spot price, .

The economists John Maynard Keynes

and John Hicks argued that in general,
the natural hedgers of a commodity are
those who wish to sell the commodity
at a future point in time.[3] [4] Thus,
hedgers will collectively hold a net short position in the forward market. The other side of these contracts are held by
speculators, who must therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept
Forward contract 23

losing money on their forward contracts. Speculators on the other hand, are interested in making a profit, and will
hence only enter the contracts if they expect to make money. Thus, if speculators are holding a net long position, it
must be the case that the expected future spot price is greater than the forward price.
In other words, the expected payoff to the speculator at maturity is:
, where is the delivery price at maturity
Thus, if the speculators expect to profit,

, as when they enter the contract

This market situation, where , is referred to as normal backwardation. Since forward/futures prices
converge with the spot price at maturity (see Basis), normal backwardation implies that futures prices for a certain
maturity are increasing over time. The opposite situation, where , is referred to as contango.
Likewise, contango implies that futures prices for a certain maturity are falling over time.[5]

Rational pricing
If is the spot price of an asset at time , and is the continuously compounded rate, then the forward price at a
future time must satisfy .
To prove this, suppose not. Then we have two possible cases.

Case 1: Suppose that . Then an investor can execute the following trades at time :
1. go to the bank and get a loan with amount at the continuously compounded rate r;
2. with this money from the bank, buy one unit of stock for ;
3. enter into one short forward contract costing 0. A short forward contract means that the investor owes the
counterparty the stock at time .
The initial cost of the trades at the initial time sum to zero.
At time the investor can reverse the trades that were executed at time . Specifically, and mirroring the trades 1.,
2. and 3. the investor
1. ' repays the loan to the bank. The inflow to the investor is ;
2. ' settles the short forward contract by selling the stock for . The cash inflow to the investor is now
because the buyer receives from the investor.
The sum of the inflows in 1.' and 2.' equals , which by hypothesis, is positive. This is an
arbitrage profit. Consequently, and assuming that the non-arbitrage condition holds, we have a contradiction. This is
called a cash and carry arbitrage because you "carry" the stock until maturity.
Case 2: Suppose that . Then an investor can do the reverse of what he has done above in case 1.
But if you look at the convenience yield page, you will see that if there are finite stocks/inventory, the reverse cash
and carry arbitrage is not always possible. It would depend on the elasticity of demand for forward contracts and
such like.
Forward contract 24

Extensions to the forward pricing formula

Suppose that is the time value of cash flows X at the contract expiration time . The forward price is
then given by the formula:

The cash flows can be in the form of dividends from the asset, or costs of maintaining the asset.
If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed
above. One implication of this is that the presence of a forward market will force spot prices to reflect current
expectations of future prices. As a result, the forward price for nonperishable commodities, securities or currency is
no more a predictor of future price than the spot price is - the relationship between forward and spot prices is driven
by interest rates. For perishable commodities, arbitrage does not have this
The above forward pricing formula can also be written as:

Where is the time t value of all cash flows over the life of the contract.
For more details about pricing, see forward price.

Theories of why a forward contract exists

Allaz and Vila (1993) suggest that there is also a strategic reason (in an imperfect competitive environment) for the
existence of forward trading, that is, forward trading can be used even in a world without uncertainty. This is due to
firms having Stackelberg incentives to anticipate their production through forward contracts.

[1] John C Hull, Options, Futures and Other Derivatives (6th edition), Prentice Hall: New Jersey, USA, 2006, 3
[2] Forward Contract on Wikinvest
[3] J.M. Keynes, A Treatise on Money, London: Macmillan, 1930
[4] J.R. Hicks, Value and Capital, Oxford: Clarendon Press, 1939
[5] Contango Vs. Normal Backwardation (http:/ / www. investopedia. com/ articles/ 07/ contango_backwardation. asp), Investopedia

• John C. Hull, (2000), Options, Futures and other Derivatives, Prentice-Hall.
• Keith Redhead, (31 October 1996), Financial Derivatives: An Introduction to Futures, Forwards, Options and
Swaps, Prentice-Hall
• Abraham Lioui & Patrice Poncet, (March 30, 2005), Dynamic Asset Allocation with Forwards and Futures,
• Check Yahoo answers (http://answers.yahoo.com/question/index;_ylt=Amc.
• Forward Contract on Wikinvest

Further reading
• Allaz, B. and Vila, J.-L., Cournot competition, futures markets and efficiency, Journal of Economic Theory
Option (finance) 25

Option (finance)
In finance, an option is a derivative financial instrument that establishes a contract between two parties concerning
the buying or selling of an asset at a reference price. The buyer of the option gains the right, but not the obligation, to
engage in some specific transaction on the asset, while the seller incurs the obligation to fulfill the transaction if so
requested by the buyer. The price of an option derives from the difference between the reference price and the value
of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the
time remaining until the expiration of the option. Other types of options exist, and options can in principle be created
for any type of valuable asset.
An option which conveys the right to buy something is called a call; an option which conveys the right to sell is
called a put. The reference price at which the underlying may be traded is called the strike price or exercise price.
The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as
exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes
void and worthless.
In return for granting the option, called writing the option, the originator of the option collects a payment, the
premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset
or its cash equivalent, if the option is exercised.
An option can usually be sold by its original buyer to another party. Many options are created in standardized form
and traded on an anonymous options exchange among the general public, while other over-the-counter options are
customized to the desires of the buyer on an ad hoc basis, usually by an investment bank.[1] [2]

Option valuation
The theoretical value of an option is evaluated according to any of several mathematical models. These models,
which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to
changing conditions. For example how the price changes with respect to changes in time to expiration or how an
increase in volatility would have an impact on the value. Hence, the risks associated with granting, owning, or
trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other
investments. Exchange-traded options form an important class of options which have standardized contract features
and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded
between private parties, often well-capitalized institutions that have negotiated separate trading and clearing
arrangements with each other.

Contract specifications
Every financial option is a contract between the two counterparties with the terms of the option specified in a term
sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following
• whether the option holder has the right to buy (a call option) or the right to sell (a put option)
• the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
• the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur
upon exercise
• the expiration date, or expiry, which is the last date the option can be exercised
• the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply
tender the equivalent cash amount
• the terms by which the option is quoted in the market to convert the quoted price into the actual premium-–the
total amount paid by the holder to the writer of the option.
Option (finance) 26

The primary types of financial options are:
• Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. Exchange
traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed
by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available.
Exchange-traded options include:[4] [5]
• stock options,
• commodity options,
• bond options and other interest rate options
• stock market index options or, simply, index options and
• options on futures contracts
• callable bull/bear contract
• Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties,
and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored
to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized
institution. Option types commonly traded over the counter include:
1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a
company to their employees as a form of incentive compensation. Other types of options exist in many financial
contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options
are usually included in mortgage loans. However, many of the valuation and risk management principles apply
across all financial options.

Option styles
Naming conventions are used to help identify properties common to many different types of options. These include:
• European option - an option that may only be exercised on expiration.
• American option - an option that may be exercised on any trading day on or before expiry.
• Bermudan option - an option that may be exercised only on specified dates on or before expiration.
• Barrier option - any option with the general characteristic that the underlying security's price must pass a certain
level or "barrier" before it can be exercised
• Exotic option - any of a broad category of options that may include complex financial structures.[6]
• Vanilla option - any option that is not exotic.
Option (finance) 27

Valuation models
The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk
neutral pricing and using stochastic calculus. The most basic model is the Black-Scholes model. More sophisticated
models are used to model the volatility smile. These models are implemented using a variety of numerical
techniques.[7] In general, standard option valuation models depend on the following factors:
• The current market price of the underlying security,
• the strike price of the option, particularly in relation to the current market price of the underlier (in the money vs.
out of the money),
• the cost of holding a position in the underlying security, including interest and dividends,
• the time to expiration together with any restrictions on when exercise may occur, and
• an estimate of the future volatility of the underlying security's price over the life of the option.
More advanced models can require additional factors, such as an estimate of how volatility changes over time and
for various underlying price levels, or the dynamics of stochastic interest rates.
The following are some of the principal valuation techniques used in practice to evaluate option contracts.

Following early work by Louis Bachelier and later work by Edward O. Thorp, Fischer Black and Myron Scholes
made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative
dependent on a non-dividend-paying stock. By employing the technique of constructing a risk neutral portfolio that
replicates the returns of holding an option, Black and Scholes produced a closed-form solution for a European
option's theoretical price.[8] At the same time, the model generates hedge parameters necessary for effective risk
management of option holdings. While the ideas behind the Black-Scholes model were ground-breaking and
eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for Achievement in
Economics (a.k.a., the Nobel Prize in Economics),[9] the application of the model in actual options trading is clumsy
because of the assumptions of continuous (or no) dividend payment, constant volatility, and a constant interest rate.
Nevertheless, the Black-Scholes model is still one of the most important methods and foundations for the existing
financial market in which the result is within the reasonable range.[10]

Stochastic volatility models

Since the market crash of 1987, it has been observed that market implied volatility for options of lower strike prices
are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and for
the price level of the underlying security. Stochastic volatility models have been developed including one developed
by S.L. Heston.[11] One principal advantage of the Heston model is that it can be solved in closed-form, while other
stochastic volatility models require complex numerical methods.[11]
Option (finance) 28

Model implementation
Once a valuation model has been chosen, there are a number of different techniques used to take the mathematical
models to implement the models.

Analytic techniques
In some cases, one can take the mathematical model and using analytical methods develop closed form solutions
such as Black-Scholes and the Black model. The resulting solutions are readily computable, as are their "Greeks".

Binomial tree pricing model

Closely following the derivation of Black and Scholes, John Cox, Stephen Ross and Mark Rubinstein developed the
original version of the binomial options pricing model.[12] [13] It models the dynamics of the option's theoretical
value for discrete time intervals over the option's duration. The model starts with a binomial tree of discrete future
possible underlying stock prices. By constructing a riskless portfolio of an option and stock (as in the Black-Scholes
model) a simple formula can be used to find the option price at each node in the tree. This value can approximate the
theoretical value produced by Black Scholes, to the desired degree of precision. However, the binomial model is
considered more accurate than Black-Scholes because it is more flexible, e.g. discrete future dividend payments can
be modeled correctly at the proper forward time steps, and American options can be modeled as well as European
ones. Binomial models are widely used by professional option traders. The Trinomial tree is a similar model,
allowing for an up, down or stable path; although considered more accurate, particularly when fewer time-steps are
modelled, it is less commonly used as its implementation is more complex.

Monte Carlo models

For many classes of options, traditional valuation techniques are intractable due to the complexity of the instrument.
In these cases, a Monte Carlo approach may often be useful. Rather than attempt to solve the differential equations of
motion that describe the option's value in relation to the underlying security's price, a Monte Carlo model uses
simulation to generate random price paths of the underlying asset, each of which results in a payoff for the option.
The average of these payoffs can be discounted to yield an expectation value for the option.[14] Note though, that
despite its flexibility, using simulation for American styled options is somewhat more complex than for lattice based

Finite difference models

The equations used to model the option are often expressed as partial differential equations (see for example
Black–Scholes PDE). Once expressed in this form, a finite difference model can be derived, and the valuation
obtained. A number of implementations of finite difference methods exist for option valuation, including: explicit
finite difference, implicit finite difference and the Crank-Nicholson method. A trinomial tree option pricing model
can be shown to be a simplified application of the explicit finite difference method. Although the Finite difference
approach is mathematically sophisticated, it is particularly useful where changes are assumed over time in model
inputs - for example dividend yield, risk free rate, or volatility, or some combination of these - that are not tractable
in closed form.
Option (finance) 29

Other models
Other numerical implementations which have been used to value options include finite element methods.
Additionally, various short rate models have been developed for the valuation of interest rate derivatives, bond
options and swaptions. These, similarly, allow for closed-form, lattice-based, and simulation-based modelling, with
corresponding advantages and considerations.

As with all securities, trading options entails the risk of the option's value changing over time. However, unlike
traditional securities, the return from holding an option varies non-linearly with the value of the underlier and other
factors. Therefore, the risks associated with holding options are more complicated to understand and predict.
In general, the change in the value of an option can be derived from Ito's lemma as:

where the Greeks , , and are the standard hedge parameters calculated from an option valuation model,
such as Black-Scholes, and , and are unit changes in the underlier price, the underlier volatility and
time, respectively.
Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters
and then estimating the expected change in the model inputs, , and , provided the changes in these
values are small. This technique can be used effectively to understand and manage the risks associated with standard
options. For instance, by offsetting a holding in an option with the quantity of shares in the underlier, a trader
can form a delta neutral portfolio that is hedged from loss for small changes in the underlier price. The
corresponding price sensitivity formula for this portfolio is:

A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50, with XYZ currently trading at $48.
With future realized volatility over the life of the option estimated at 25%, the theoretical value of the option is
$1.89. The hedge parameters , , , are (0.439, 0.0631, 9.6, and -0.022), respectively. Assume that on the
following day, XYZ stock rises to $48.5 and volatility falls to 23.5%. We can calculate the estimated value of the
call option by applying the hedge parameters to the new model inputs as:

Under this scenario, the value of the option increases by $0.0614 to $1.9514, realizing a profit of $6.14. Note that for
a delta neutral portfolio, where by the trader had also sold 44 shares of XYZ stock as a hedge, the net loss under the
same scenario would be ($15.86).

Pin risk
A special situation called pin risk can arise when the underlier closes at or very close to the option's strike value on
the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or
not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up
with a large, unwanted residual position in the underlier when the markets open on the next trading day after
expiration, regardless of their best efforts to avoid such a residual.
Option (finance) 30

Counterparty risk
A further, often ignored, risk in derivatives such as options is counterparty risk. In an option contract this risk is that
the seller won't sell or buy the underlying asset as agreed. The risk can be minimized by using a financially strong
intermediary able to make good on the trade, but in a major panic or crash the number of defaults can overwhelm
even the strongest intermediaries.

The most common way to trade options is via standardized options contracts that are listed by various futures and
options exchanges. [15] Listings and prices are tracked and can be looked up by ticker symbol. By publishing
continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and
execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the
transaction include:
• fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA),
• counterparties remain anonymous,
• enforcement of market regulation to ensure fairness and transparency, and
• maintenance of orderly markets, especially during fast trading conditions.
Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties.
Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC
options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition,
OTC option transactions generally do not need to be advertised to the market and face little or no regulatory
requirements. However, OTC counterparties must establish credit lines with each other, and conform to each others
clearing and settlement procedures.
With few exceptions,[16] there are no secondary markets for employee stock options. These must either be exercised
by the original grantee or allowed to expire worthless.

The basic trades of traded stock options (American style)

These trades are described from the point of view of a speculator. If they are combined with other positions, they can
also be used in hedging. An option contract in US markets usually represents 100 shares of the underlying

Long call
A trader who believes that a stock's price will increase might buy
the right to purchase the stock (a call option) rather than just
purchase the stock itself. He would have no obligation to buy the
stock, only the right to do so until the expiration date. If the stock
price at expiration is above the exercise price by more than the
premium (price) paid, he will profit. If the stock price at expiration
is lower than the exercise price, he will let the call contract expire
worthless, and only lose the amount of the premium. A trader
might buy the option instead of shares, because for the same
Payoff from buying a call.
amount of money, he can control (leverage) a much larger number
of shares.
Option (finance) 31

Long put
A trader who believes that a stock's price will decrease can buy
the right to sell the stock at a fixed price (a put option). He will be
under no obligation to sell the stock, but has the right to do so until
the expiration date. If the stock price at expiration is below the
exercise price by more than the premium paid, he will profit. If the
stock price at expiration is above the exercise price, he will let the
put contract expire worthless and only lose the premium paid.

Payoff from buying a put.

Short call
A trader who believes that a stock price will decrease, can sell the
stock short or instead sell, or "write," a call. The trader selling a
call has an obligation to sell the stock to the call buyer at the
buyer's option. If the stock price decreases, the short call position
will make a profit in the amount of the premium. If the stock price
increases over the exercise price by more than the amount of the
premium, the short will lose money, with the potential loss

Payoff from writing a call.

Short put
A trader who believes that a stock price will increase can buy the
stock or instead sell a put. The trader selling a put has an
obligation to buy the stock from the put buyer at the put buyer's
option. If the stock price at expiration is above the exercise price,
the short put position will make a profit in the amount of the
premium. If the stock price at expiration is below the exercise
price by more than the amount of the premium, the trader will lose
money, with the potential loss being up to the full value of the
stock. A benchmark index for the performance of a cash-secured
Payoff from writing a put.
short put option position is the CBOE S&P 500 PutWrite Index
(ticker PUT).
Option (finance) 32

Option strategies
Combining any of the four basic kinds of option trades (possibly
with different exercise prices and maturities) and the two basic
kinds of stock trades (long and short) allows a variety of options
strategies. Simple strategies usually combine only a few trades,
while more complicated strategies can combine several.
Strategies are often used to engineer a particular risk profile to
movements in the underlying security. For example, buying a
butterfly spread (long one X1 call, short two X2 calls, and long
one X3 call) allows a trader to profit if the stock price on the Payoffs from buying a butterfly spread.
expiration date is near the middle exercise price, X2, and does not
expose the trader to a large loss.

An Iron condor is a strategy that is similar to a butterfly spread,

but with different strikes for the short options - offering a larger
likelihood of profit but with a lower net credit compared to the
butterfly spread.
Selling a straddle (selling both a put and a call at the same exercise
price) would give a trader a greater profit than a butterfly if the
final stock price is near the exercise price, but might result in a
large loss. Payoffs from selling a straddle.
Similar to the straddle is the strangle which is also constructed by
a call and a put, but whose strikes are different, reducing the net
debit of the trade, but also reducing the likelihood of profit in the
One well-known strategy is the covered call, in which a trader
buys a stock (or holds a previously-purchased long stock position),
and sells a call. If the stock price rises above the exercise price, the
call will be exercised and the trader will get a fixed profit. If the
stock price falls, the trader will lose money on his stock position,
but this will be partially offset by the premium received from
selling the call. Overall, the payoffs match the payoffs from selling Payoffs from a covered call.

a put. This relationship is known as put-call parity and offers

insights for financial theory. A benchmark index for the performance of a buy-write strategy is the CBOE S&P 500
BuyWrite Index (ticker symbol BXM).

Historical uses of options

Contracts similar to options are believed to have been used since ancient times. In the real estate market, call options
have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to
buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the
entire parcel. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific
book or script. Lines of credit give the potential borrower the right — but not the obligation — to borrow within a
specified time period.
Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds
are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the
Option (finance) 33

issuer's option. Mortgage borrowers have long had the option to repay the loan early, which corresponds to a callable
bond option.
In London, puts and "refusals" (calls) first became well-known trading instruments in the 1690s during the reign of
William and Mary.[18]
Privileges were options sold over the counter in nineteenth century America, with both puts and calls on shares
offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that
the option was bought, and the expiry date was generally three months after purchase. They were not traded in
secondary markets.
Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of
Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during
the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the
olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price
than he paid for his 'option'.[19] [20]

[1] Brealey, Richard A.; Myers, Stewart (2003), Principles of Corporate Finance (7th ed.), McGraw-Hill, Chapter 20
[2] Hull, John C. (2005), Options, Futures and Other Derivatives (excerpt by Fan Zhang) (http:/ / fan. zhang. gl/ ecref/ options) (6th ed.), Pg 6:
Prentice-Hall, ISBN 0131499084,
[3] (PDF) Characteristics and Risks of Standardized Options (http:/ / www. theocc. com/ publications/ risks/ riskstoc. pdf). Options Clearing
Corporation. . Retrieved 2007-06-21.
[4] Trade CME Products (http:/ / www. cme. com/ trading/ ), Chicago Mercantile Exchange, , retrieved 2007-06-21
[5] ISE Traded Products (http:/ / web. archive. org/ web/ 20070511003741/ http:/ / www. iseoptions. com/ products_traded. aspx), International
Securities Exchange, archived from the original (http:/ / www. iseoptions. com/ products_traded. aspx) on 2007-05-11, , retrieved 2007-06-21
[6] Fabozzi, Frank J. (2002), The Handbook of Financial Instruments (Page. 471) (1st ed.), New Jersey: John Wiley and Sons Inc,
ISBN 0-471-22092-2
[7] Reilly, Frank K.; Brown, Keith C. (2003), Investment Analysis and Portfolio Management (7th ed.), Thomson Southwestern, Chapter 23
[8] Black, Fischer and Myron S. Scholes. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy (http:/ / www.
journals. uchicago. edu/ JPE/ ), 81 (3), 637-654 (1973).
[9] Das, Satyajit (2006), Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives (6th ed.), Prentice-Hall, Chapter 1
'Financial WMDs - derivatives demagoguery,' p.22, ISBN 978-0-273-70474-4
[10] Hull, John C. (2005), Options, Futures and Other Derivatives (6th ed.), Prentice-Hall, ISBN 0131499084
[11] Jim Gatheral (2006), The Volatility Surface, A Practitioner's Guide (http:/ / www. amazon. com/
Volatility-Surface-Practitioners-Guide-Finance/ dp/ 0471792519), Wiley Finance, ISBN 978-0471792512,
[12] Cox JC, Ross SA and Rubinstein M. 1979. Options pricing: a simplified approach, Journal of Financial Economics, 7:229-263. (http:/ /
www. in-the-money. com/ artandpap/ Option Pricing - A Simplified Approach. doc)
[13] Cox, John C.; Rubinstein, Mark (1985), Options Markets, Prentice-Hall, Chapter 5
[14] Crack, Timothy Falcon (2004), Basic Black-Scholes: Option Pricing and Trading (http:/ / www. BasicBlackScholes. com/ ) (1st ed.), pp.
91-102, ISBN 0-9700552-2-6,
[15] Harris, Larry (2003), Trading and Exchanges, Oxford University Press, pp.26-27
[16] Elinor Mills (2006-12-12), Google unveils unorthodox stock option auction (http:/ / news. com. com/ Google+ unveils+ unorthodox+ stock+
option+ auction/ 2100-1030_3-6143227. html), CNet, , retrieved 2007-06-19
[17] invest-faq (http:/ / invest-faq. com/ cbc/ deriv-option-basics. html) or Law & Valuation (http:/ / www. wfu. edu/ ~palmitar/ Law& Valuation/
chapter 4/ 4-4-1. htm) for typical size of option contract
[18] Smith, B. Mark (2003), History of the Global Stock Market from Ancient Rome to Silicon Valley, University of Chicago Press, pp. 20,
ISBN 0-226-76404-4
[19] Mattias Sander. Bondesson's Representation of the Variance Gamma Model and Monte Carlo Option Pricing. Lunds Tekniska Högskola
[20] Aristotle. Politics.
Option (finance) 34

Further reading
• Fischer Black and Myron S. Scholes. "The Pricing of Options and Corporate Liabilities," Journal of Political
Economy (http://www.journals.uchicago.edu/JPE/), 81 (3), 637-654 (1973).
• Feldman, Barry and Dhuv Roy. "Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500
BuyWrite Index." The Journal of Investing (http://www.iijournals.com/JOI/default.asp), (Summer 2005).
• Kleinert, Hagen, Path Integrals in Quantum Mechanics, Statistics, Polymer Physics, and Financial Markets, 4th
edition, World Scientific (Singapore, 2004); Paperback ISBN 981-238-107-4 (also available online: PDF-files
• Hill, Joanne, Venkatesh Balasubramanian, Krag (Buzz) Gregory, and Ingrid Tierens. "Finding Alpha via Covered
Index Writing." Financial Analysts Journal (http://www.cfapubs.org/loi/faj). (Sept.-Oct. 2006). pp. 29–46.
• Moran, Matthew. “Risk-adjusted Performance for Derivatives-based Indexes – Tools to Help Stabilize Returns.”
The Journal of Indexes (http://www.indexuniverse.com/JOI/). (Fourth Quarter, 2002) pp. 34 – 40.
• Reilly, Frank and Keith C. Brown, Investment Analysis and Portfolio Management, 7th edition, Thompson
Southwestern, 2003, pp. 994–5.
• Schneeweis, Thomas, and Richard Spurgin. "The Benefits of Index Option-Based Strategies for Institutional
Portfolios" The Journal of Alternative Investments (http://www.iijournals.com/JAI/), (Spring 2001), pp. 44 –
• Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index" The Journal of Derivatives (http://
www.iijournals.com/JOD/), (Winter 2002), pp. 35 – 42.
• Bloss, Michael; Ernst, Dietmar; Häcker Joachim (2008): Derivatives - An authoritative guide to derivatives for
financial intermediaries and investors Oldenbourg Verlag München ISBN 978-3-486-58632-9
• Espen Gaarder Haug & Nassim Nicholas Taleb (2008): "Why We Have Never Used the Black-Scholes-Merton
Option Pricing Formula" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1012075&rec=1&

External links
• Robert Shiller: Video lecture about Option Markets (http://www.academicearth.org/lectures/options-markets)
• List of equities with options (http://www.cboe.com/TradTool/Symbols/SymbolEquity.aspx)
• A spreadsheet options market scale (http://www.aegis-bearing.net/wheat.aspx)
Call option 35

Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of
this type of option.[1] The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a
particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the
expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or
financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects
that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid
immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlying instrument moves up, making the price of the
underlying instrument closer to, or above, the strike price. The call buyer believes it's likely the price of the
underlying asset will rise by the exercise date. The risk is limited to the premium. The profit for the buyer can be
very large, and is limited by how high underlying's spot rises. When the price of the underlying instrument surpasses
the strike price, the option is said to be "in the money".
The call writer does not believe the price of the underlying security is likely to rise. The writer sells the call to collect
the premium. The total loss, for the call writer, can be very large, and is only limited by how high the underlying's
spot price rises.
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial
asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a
fee - the option price or premium.
Exact specifications may differ depending on option style. A European call option allows the holder to exercise the
option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during
the life of the option.
Call options can be purchased on many financial instruments other than stock in a corporation. Options can be
purchased on futures on interest rates, for example (see interest rate cap), and on commodities like gold or crude oil.
A tradeable call option should not be confused with either Incentive stock options or with a warrant. An incentive
stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular
person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are
issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the
underlying asset is transferred from one owner to another.

Example of a call option on a stock

An investor typically 'buys a call' when he expects the price of the
underlying instrument will go above the call's 'strike price,'
hopefully significantly so, before the call expires. The investor
pays a non-refundable premium for the legal right to exercise the
call at the strike price, meaning he can purchase the underlying
instrument at the strike price. Typically, if the price of the
underlying instrument has surpassed the strike price, the buyer
pays the strike price to actually purchase the underlying
instrument, and then sells the instrument and pockets the profit. Of
Payoff from buying a call.
course, the investor can also hold onto the underlying instrument,
if he feels it will continue to climb even higher.
Call option 36

An investor typically 'writes a call' when he expects the price of

the underlying instrument to stay below the call's strike price. The
writer (seller) receives the premium up front as his or her profit.
However, if the call buyer decides to exercise his option to buy,
then the writer has the obligation to sell the underlying instrument
at the strike price. Oftentimes the writer of the call does not
actually own the underlying instrument, and must purchase it on
the open market in order to be able to sell it to the buyer of the
call. The seller of the call will lose the difference between his or
Payoff from writing a call.
her purchase price of the underlying instrument and the strike
price. This risk can be huge if the underlying instrument
skyrockets unexpectedly in price.
• The current price of ABC Corp stock is $45 per share, and investor 'Chris' expects it will go up significantly.
Chris buys a call contract for 100 shares of ABC Corp from 'Steve,' who is the call writer/seller. The strike price
for the contract is $50 per share, and Chris pays a premium up front of $5 per share, or $500 total. If ABC Corp
does not go up, and Chris does not exercise the contract, then Chris has lost $500.
• ABC Corp stock subsequently goes up to $60 per share before the contract is expired. Chris exercises the call
option by buying 100 shares of ABC from Steve for a total of $5,000. Chris then sells the stock on the market at
market price for a total of $6,000. Chris has paid a $500 contract premium plus a stock cost of $5,000, for a total
of $5,500. He has earned back $6,000, yielding a net profit of $500. Steve, however, did not do so well. Steve did
not already own ABC Corp stock, so when Chris exercised the contract, Steve had to buy the stock on the open
market for $6,000. Steve had already earned the $500 premium for the contract and $5,000 from Chris on selling
the stock, so the total loss for Steve was $500.
• If, however, the ABC stock price drops to $40 per share by the time the contract expires, Chris will not exercise
the option (i.e., Chris will not buy a stock at $50 per share from Steve when he can buy it on the open market at
$40 per share). Chris loses his premium, a total of $500. Steve, however, keeps the premium with no other
out-of-pocket expenses, making a profit of $500.
• The break-even stock price for Chris is $55 per share, i.e., the $50 per share for the call option price plus the $5
per share premium he paid for the option. If the stock reaches $55 per share when the option expires, Chris can
recover his investment by exercising the option and buying 100 shares of ABC Corp stock from Steve at $50 per
share, and then immediately selling those shares at the market price of $55. His total costs are then the $5 per
share premium for the call option, plus $50 per share to buy the shares from Steve, for a total of $5,500. His total
earnings are $55 per share sold, or $5,500 for 100 shares, yielding him a net $0. (Note that this does not take into
account broker fees or other transaction costs.)

Value of a call
This examples lead to the following formal reasoning. Fix an underlying financial instrument. Let be a call
option for this instrument, purchased at time , expiring at time , with exercise (strike) price ;
and let be the price of the underlying instrument.
Assume the owner of the option , wants to make no loss, and does not want to actually possess the underlying
instrument, . Then either (i) the person will exercise the option and purchase , and then immediately sell it;
or (ii) the person will not exercise the option (which subsequently becomes worthless). In (i), the pay-off would be
; in (ii) the pay-off would be . So if (i) or (ii) occurs; if then (ii)
Hence the pay-off, i.e. the value of the call option at expiry, is
Call option 37

which is also written or .

Price of options
Option values vary with the value of the underlying instrument over time. The price of the call contract must reflect
the "likelihood" or chance of the call finishing "in-the-money." The call contract price generally will be higher when
the contract has more time to expire (except in cases when a significant dividend is present) and when the underlying
financial instrument shows more volatile. Determining this value is one of the central functions of financial
mathematics. The most common method used is the Black-Scholes formula. Whatever the formula used, the buyer
and seller must agree on the initial value (the premium or price of the call contract), otherwise the exchange
(buy/sell) of the call will not take place.

• Binary option
• Bond option
• Credit default option
• Exotic interest rate option
• Foreign exchange option
• Interest rate cap and floor
• Options on futures
• Stock option
• Swaption
• Warrant (finance)

[1] Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http:/ / www. pearsonschool. com/ index.
cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). Upper
Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 288. ISBN 0-13-063085-3. .
Put option 38

Put option
A put option (usually just called a "put") is a financial contract between two parties, the writer (seller) and the buyer
of the option. The buyer acquires a short position by purchasing the right to sell the underlying instrument to the
seller of the option for a specified price (the strike price) during a specified period of time. If the option buyer
exercises his right, the seller is obligated to buy the underlying instrument from him at the agreed-upon strike price,
regardless of the current market price. In exchange for having this option, the buyer pays the seller or option writer a
fee (the option premium).
By providing a guaranteed buyer and price for an underlying instrument (for a specified span of time), put options
offer insurance against excessive loss. Similarly, the seller of put options profits by selling options that are not
exercised. Such is the case when the ongoing market value of the underlying instrument makes the option
unnecessary; i.e. the market value of the instrument remains above the strike price during the option contract period.
Purchasers of put options may also profit from the ability to sell the underlying instrument at an inflated price
(relative to the current market value) and repurchase their position at the much reduced current market price.

Instrument models
The terms for exercising the option's right to sell it differ depending on option style. A European put option allows
the holder to exercise the put option for a short period of time right before expiration, while an American put option
allows exercise at any time before expiration.
The most widely-traded put options are on equities, but they are traded on many other instruments such as interest
rates (see interest rate floor) or commodities.
The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long
position in it. The advantage of buying a put over short selling the asset is that the option owner's risk of loss is
limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited (its price can rise greatly,
in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.) The put buyer's prospect (risk) of gain
is limited to the option's strike price less the underlying's spot price and the premium/fee paid for it.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the
premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already
received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.
A naked put, also called an uncovered put, is a put option whose writer (the seller) does not have a position in the
underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the
underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps
the option premium as a 'gift' for playing the game.
If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner
(buyer) can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the
exerciser (buyer) to profit from the difference between the stock's market price and the option's strike price. But if
the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless,
and the owner's loss is limited to the premium (fee) paid for it (the writer's profit).
The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero (bankruptcy), his
loss is equal to the strike price (at which he must buy the stock to cover the option) minus the premium received. The
potential upside is the premium received when selling the option: if the stock price is above the strike price at
expiration, the option seller keeps the premium, and the option expires worthless. During the option's lifetime, if the
stock moves lower, the option's premium may increase (depending on how far the stock falls and how much time
passes). If it does, it becomes more costly to close the position (repurchase the put, sold earlier), resulting in a loss. If
the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic
Put option 39


Example of a put option on a stock

Buying a put
A Buyer thinks the price of a stock will decrease. He pays a
premium which he will never get back, unless it is sold before it
expires. The buyer has the right to sell the stock at the strike price.
Writing a put
The writer receives a premium from the buyer. If the buyer
exercises his option, the writer will buy the stock at the strike
price. If the buyer does not exercise his option, the writer's profit is
the premium. Payoff from buying a put.

• 'Trader A' (Put Buyer) purchases a put contract to sell 100

shares of XYZ Corp. to 'Trader B' (Put Writer) for $50 per
share. The current price is $55 per share, and 'Trader A' pays a
premium of $5 per share. If the price of XYZ stock falls to $40
a share right before expiration, then 'Trader A' can exercise the
put by buying 100 shares for $4,000 from the stock market,
then selling them to 'Trader B' for $5,000.

Trader A's total earnings (S) can be calculated at $500. The

sale of the 100 shares of stock at a strike price of $50 to
'Trader B' = $5,000 (P). The purchase of 100 shares of stock Payoff from writing a put.
at $40 = $4,000 (Q). The put option premium paid to trader
B for buying the contract of 100 shares at $5 per share, excluding commissions = $500 (R). Thus S = P -
(Q+R) = $5,000 - ($4,000+$500) = $500.

• If, however, the share price never drops below the strike price (in this case, $50), then 'Trader A' would not
exercise the option (because selling a stock to 'Trader B' at $50 would cost 'Trader A' more than that to buy it).
Trader A's option would be worthless and he would have lost the whole investment, the fee (premium) for the
option contract, $500 (5 per share, 100 shares per contract). Trader A's total loss are limited to the cost of the put
premium plus the sales commission to buy it.
A put option is said to have intrinsic value when the underlying instrument has a spot price (S) below the option's
strike price (K). Upon exercise, a put option is valued at K-S if it is "in-the-money", otherwise its value is zero. Prior
to exercise, an option has time value apart from its intrinsic value. The following factors reduce the time value of a
put option: shortening of the time to expire, decrease in the volatility of the underlying, and increase of interest rates.
Option pricing is a central problem of financial mathematics.
Put option 40

Value of a put
This examples lead to the following formal reasoning. Fix an underlying financial instrument. Let be a put
option for this instrument, purchased at time , expiring at time , with exercise (strike) price ;
and let be the price of the underlying instrument.
Assume the owner of the option , wants to make no loss, and does not want to actually possess the underlying
instrument, . Then either (i) the person will purchase at expiry, and then immediately exercise the selling
option; or (ii) the person will not exercise the option (which subsequently becomes worthless). In (i), the pay-off
would be ; in (ii) the pay-off would be . So if (i) or (ii) occurs; if
then (ii) occurs.
Hence the pay-off, i.e. the value of the put option at expiry, is

which is alternatively written or .

External links
• Basic Options Concepts: Put Options [1] - at Yahoo! Finance

[1] http:/ / biz. yahoo. com/ opt/ basics4. html

Strike price
In options, the strike price (or exercise price ) is a key variable in a derivatives contract between two parties. Where
the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot
price (market price) of the underlying instrument at that time.
Formally, the strike price can be defined as the fixed price at which the owner of an option can purchase (in the case
of a call), or sell (in the case of a put), the underlying security or commodity.
For example, an IBM May 50 Call has a strike price of $50 a share. When the option is exercised the owner of the
option will buy 100 shares of IBM stock for $50 per share.

Moneyness is a term describing the relationship between the strike price of an option and the current trading price of
its underlying security. Where settlement is financial, the difference between the strike price and the spot price will
determine the value, or "moneyness", of the contract.
In options trading, terms such as in-the-money, at-the-money and out-of-the-money describe the moneyness of
options. A call option is said to be in-the-money if the stock price is trading above the strike price. A put option is
in-the-money if the strike price is higher than the market price of the underlying stock. A call or put option is
at-the-money if the stock price and the exercise price are the same. A call option is said to be out-of-the-money if the
stock price is lower than the exercise price of the option. A put option is out-of-the money if the stock price is higher
than the exercise price of the option.
Strike price 41

Mathematical Formula
A call option has positive monetary value at expiration when the underlying has a spot price (S) above the strike
price (K). Since the option will not be exercised unless it is in-the-money, the payoff for a call option is

also written as


A put option has positive monetary value at expiration when the underlying has a spot price below the strike price; it
is "out-the-money" otherwise, and will not be exercised. The payoff is therefore:


For a digital option payoff is , where is the indicator function.

• McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York Institute
of Finance. ISBN 0-7352-0197-8.

External links
1. Stock option strike price [1]

[1] http:/ / www. learn-stock-options-trading. com/ strike-price. html
Swap (finance) 42

Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial
instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial
instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the
periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to
exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap
agreement defines the dates when the cash flows are to be paid and the way they are calculated.[1] Usually at the time
when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain
variable such as an interest rate, foreign exchange rate, equity price or commodity price.[1]
The cash flows are calculated over a notional principal amount, which is usually not exchanged between
counterparties. Consequently, swaps can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected
direction of underlying prices.
The first swaps were negotiated in the early 1980s.[1] David Swensen, a Yale Ph.D. at Salomon Brothers, engineered
the first swap transaction according to "When Genius Failed: The Rise and Fall of Long-Term Capital Management"
by Roger Lowenstein. Today, swaps are among the most heavily traded financial contracts in the world: the total
amount of interest rates and currency swaps outstanding is more thаn $426.7 trillion in 2009, according to
International Swaps and Derivatives Association (ISDA).

Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also
exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures
market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG.
The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC
derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world
product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the
cash flow generated from swaps is a substantial fraction of but much less than the gross world product—which is
also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by
currency as:

The CDS and currency swap markets are dwarfed by the interest rate swap market. All
three markets peaked in mid 2008.
Source: BIS Semiannual OTC derivatives statistics at end-December 2008
Swap (finance) 43

Notional outstanding
in USD trillion

Currency End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006

Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1

US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6

Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0

Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3

Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5

Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0

Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [2], "OTC Derivatives Market Activity in the Second Half of
2006", BIS, [3]

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a
swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to
avoid any conflict of interest. For instance, LIBOR is published by the British Bankers Association, an independent
trade body.

Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps,
credit swaps, commodity swaps and equity swaps. There are also many other types.

Interest rate swaps

The most common type of swap is a
“plain Vanilla” interest rate swap. It is
the exchange of a fixed rate loan to a
floating rate loan. The life of the swap
can range from 2 years to over 15
years. The reason for this exchange is
to take benefit from comparative
advantage. Some companies may have
comparative advantage in fixed rate
markets while other companies have a
comparative advantage in floating rate A is currently paying floating, but wants to pay fixed. B is currently paying fixed but
markets. When companies want to wants to pay floating. By entering into an interest rate swap, the net result is that each
party can 'swap' their existing obligation for their desired obligation. Normally the parties
borrow they look for cheap borrowing
do not swap payments directly, but rather, each sets up a separate swap with a financial
i.e. from the market where they have intermediary such as a bank. In return for matching the two parties together, the bank
comparative advantage. However this takes a spread from the swap payments.
may lead to a company borrowing
fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has
the effect of transforming a fixed rate loan into a floating rate loan or vice versa.currency

For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70
basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are
calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each
interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A
Swap (finance) 44

and B is slightly lower due to a bank taking a spread.

Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for
principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the
currency swaps also are motivated by comparative advantage. Currency swaps entail swapping both principal and
interest between the parties, with the cashflows in one direction being in a different currency than those in the
opposite direction.

Commodity swaps
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a
specified period. The vast majority of commodity swaps involve crude oil.

Equity Swap
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a
stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you
do not have any voting or other rights that stock holders do.

Credit default swaps

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the
seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to
pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring,
bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance,
because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the
contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also
cover an asset to which the buyer has no direct exposure.

Other variations
There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of
financial engineers and the desire of corporate treasurers and fund managers for exotic structures.[1]
• A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic
interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if
the total return is negative, then party A receives this amount from party B. The parties have exposure to the
return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B
is the same for him as actually owning the underlying asset.
• An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future
time to enter into a swap.
• A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with
the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a
• An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments
declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate
benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate
risk involved in predicted funding requirement, or investment programs.
• A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the
same time would like to conserve cash for operational purposes.
Swap (finance) 45

• A Deferred rate swap is particularly attractive to those users of funds that need funds immedatiely but do not
consider the current rates of interest very attractive and feel that the rates may fall in future.
• An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that
they may fund projects.
• A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose
of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start
swap, and a deferred start swap.

The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it
is first initiated, however after this time its value may become positive or negative.[1] There are two ways to value
swaps: in terms of bond prices, or as a portfolio of forward contracts.[1]

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the
end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap position in
a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. making
floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the
swap. Thus, the home currency value is:
, where is the domestic cash flows of the swap, is
the foreign cash flows of the LIBOR is the rate of interest offered by banks on deposit from other banks in the
eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three
months deposits, etc.
LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just
like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International

Arbitrage arguments
As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash
flows is equal to zero. Where this is not the case, arbitrage would be possible.
For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party
B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate
payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is
zero). Where this is not the case, an Arbitrageur, C, could:
1. assume the position with the lower present value of payments, and borrow funds equal to this present value
2. meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding
payments - which have a higher present value
3. use the received payments to repay the debt on the borrowed funds
4. pocket the difference - where the difference between the present value of the loan and the present value of the
inflows is the arbitrage profit.
Swap (finance) 46

Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments
as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and
use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated
to service the instrument which he is short.

• Financial Institutions Management, Saunders A. & Cornett M., McGraw-Hill Irwin 2006
[1] John C Hull, Options, Futures and Other Derivatives (6th edition), New Jersey: Prentice Hall, 2006, 149
[2] http:/ / www. bis. org/ publ/ otc_hy0505. htm
[3] http:/ / www. bis. org/ publ/ otc_hy0705. pdf

External links
• swaps index (http://www.quantnotes.com/fundamentals/swaps/index.htm), quantnotes.com
• swaps-rates.com (http://www.swap-rates.com/), interest swap rates statistics online
• Bank for International Settlements (http://www.bis.org)
• International Swaps and Derivatives Association (http://isda.org)

Interest rate derivative

An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount
of money at a given interest rate. These structures are popular for investors with customized cashflow needs or
specific views on the interest rate movements (such as volatility movements or simple directional movements) and
are therefore usually traded OTC; see financial engineering.
The interest rate derivatives market is the largest derivatives market in the world. The Bank for International
Settlements estimates that the notional amount outstanding in June 2009 [1] were US$437 trillion for OTC interest
rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and
Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to
control their cashflows. This compares with 75% for foreign exchange options, 25% for commodity options and 10%
for stock options.
Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensional Lattice ("tree") built for
the underlying risk drivers, usually domestic or foreign short rates and Forex rates; see Short-rate model. Specialised
simulation models are also often used.


The basic building blocks for most interest rate derivatives can be described as "vanilla" (simple, basic derivative
structures, usually most liquid):
• Interest rate swap (fixed-for-floating)
• Interest rate cap or interest rate floor
• Interest rate swaption
• Bond option
• Forward rate agreement
• Interest rate future
• Money market instruments
Interest rate derivative 47

• Cross currency swap (see Forex swap)

The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives, examples of which are:
• Range accrual swaps/notes/bonds
• In-arrears swap
• Constant maturity swap (CMS) or constant treasury swap (CTS) derivatives (swaps, caps, floors)
• Interest rate swap based upon two floating interest rates

Exotic derivatives
Building off these structures are the "exotic" interest rate derivatives (least liquid, traded over the counter), such as:
• Power Reverse Dual Currency note (PRDC or Turbo)
• Target redemption note (TARN)
• CMS steepener [2]
• Snowball [3]
• Inverse floater
• Strips of Collateralized mortgage obligation
• Ratchet caps and floors
• Bermudan swaptions
• Cross currency swaptions
Most of the exotic interest rate derivatives are structured as swaps or notes, and can be classified as having two
payment legs: a funding leg and an exotic coupon leg.
• A funding leg usually consists of series of fixed coupons or floating coupons (LIBOR) plus fixed spread.
• An exotic coupon leg typically consists of a functional dependence on the past and current underlying indices
(LIBOR, CMS rate, FX rate) and sometimes on its own past levels, as in Snowballs and TARNs. The payer of the
exotic coupon leg usually has a right to cancel the deal on any of the coupon payment dates, resulting in the
so-called Bermudan exercise feature. There may also be some range-accrual and knock-out features inherent in
the exotic coupon definition.

Example of interest rate derivatives

Interest rate cap

An interest rate cap is designed to hedge a company’s maximum exposure to upward interest rate movements. It
establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. The interest rate
cap is actually a series of individual interest rate caplets, each being an individual option on the underlying interest
rate index. The interest rate cap is paid for upfront, and then the purchaser realizes the benefit of the cap over the life
of the instrument.

Range accrual note

Suppose a manager wished to take a view that volatility of interest rates will be low. He or she may gain extra yield
over a regular bond by buying a range accrual note instead. This note pays interest only if the floating interest rate
(i.e.London Interbank Offered Rate) stays within a pre-determined band. This note effectively contains an embedded
option which, in this case, the buyer of the note has sold to the issuer. This option adds to the yield of the note. In
this way, if volatility remains low, the bond yields more than a standard bond.
Interest rate derivative 48

Bermudan swaption
Suppose a fixed-coupon callable bond was brought to the market by a company. The issuer however, entered into an
interest rate swap to convert the fixed coupon payments to floating payments (perhaps based on LIBOR). Since it is
callable however, the issuer may redeem the bond back from investors at certain dates during the life of the bond. If
called, this would still leave the issuer with the interest rate swap. Therefore, the issuer also enters into Bermudan
swaption when the bond is brought to market with exercise dates equal to callable dates for the bond. If the bond is
called, the swaption is exercised, effectively canceling the swap leaving no more interest rate exposure for the issuer.

[1] Bank for International Settlements "Semiannual OTC derivatives statistics" (http:/ / www. bis. org/ statistics/ otcder/ dt1920a. csv) at
end-June 2009. Retrieved 31 January 2010
[2] http:/ / www. risk. net/ asia-risk/ feature/ 1496874/ rate-steepeners-rise
[3] http:/ / www. fincad. com/ derivatives-resources/ wiki/ snowballs. aspx

Further reading
• Hull, John C. (2005) Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. ISBN 0131499084
• Marhsall, John F (2000). Dictionary of Financial Engineering. Wiley. ISBN 0471242918
• Damiano Brigo, Fabio Mercurio (2001). Interest Rate Models - Theory and Practice with Smile, Inflation and
Credit (2nd ed. 2006 ed.). Springer Verlag. ISBN 978-3-540-22149-4.
• Leif B.G. Andersen, Vladimir V. Piterbarg (2010). Interest Rate Modeling in Three Volumes (http://www.
andersen-piterbarg-book.com) (1st ed. 2010 ed.). Atlantic Financial Press. ISBN 978-0-9844221-0-4.

External links
• Basic Fixed Income Derivative Hedging (http://www.financial-edu.com/
basic-fixed-income-derivative-hedging.php) - Article on Financial-edu.com.
• Interest Rate Modeling (http://www.andersen-piterbarg-book.com) by L. Andersen and V. Piterbarg
Foreign exchange derivative 49

Foreign exchange derivative

A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its
exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign
exchange risk. For detail see:
• Foreign exchange option
• Forex swap
• Currency future
• Currency swap
• Foreign exchange hedge
• Binary option: Foreign exchange

Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an
underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the
counterparties to the transaction itself.[1] This entity is known as the reference entity and may be a corporate, a
sovereign or any other form of legal entity which has incurred debt.[2] Credit derivatives are bilateral contracts
between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.[2]
Stated in plain language, a credit derivative is a wager, and the reference entity is the thing being wagered on.
Similar to placing a bet at the racetrack, where the person placing the bet does not own the horse or the track or have
anything else to do with the race, the person buying the credit derivative doesn't necessarily own the bond (the
reference entity) that is the object of the wager. He or she simply believes that there is a good chance that the bond or
collateralized debt obligation (CDO) in question will default (go to zero value). Originally conceived as a kind of
insurance policy for owners of bonds or CDO's, it evolved into a freestanding investment strategy. The cost might be
as low as 1% per year. If the buyer of the derivative believes the underlying bond will go bust within a year (usually
an extremely unlikely event) the buyer stands to reap a 100 fold profit. A small handful of investors anticipated the
credit crunch of 2007/8 and made billions placing "bets" via this method.
The parties will select which credit events apply to a transaction and these usually consist of one or more of the
• bankruptcy (the risk that the reference entity will become bankrupt)
• failure to pay (the risk that the reference entity will default on one of its obligations such as a bond or loan)
• obligation default (the risk that the reference entity will default on any of its obligations)
• obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be
declared immediately due and payable following a default)
• repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the
reference entity's obligations)
• restructuring (the risk that obligations of the reference entity will be restructured)...
Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit
derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and
payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued
by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
This synthetic securitization process has become increasingly popular over the last decade, with the simple versions
of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name a few. In
funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different
Credit derivative 50

slices of credit risk according to their risk appetite.

Market size and participants

Credit default products are the most commonly traded credit derivative product[3] and include unfunded products
such as credit default swaps and funded products such as collateralized debt obligations (see further discussion
The ISDA[4] reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion
with a gross market value of $948 billion (ISDA's Website [5]). As reported in The Times on September 15, 2008,
the "Worldwide credit derivatives market is valued at $62 trillion". [6]
Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of
Europe having about 10%.[3]
The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates.[3]

Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit
derivatives. An unfunded credit derivative is a bilateral contract between two counterparties, where each party is
responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical
settlement amount) itself without recourse to other assets. A funded credit derivative involves the protection seller
(the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events.
However, the protection buyer is exposed to the credit risk of the protection seller, in which case the protection seller
fails to pay the protection buyer under the event of the protection seller's default. It is also known as counterparty
Unfunded credit derivative products include the following products:
• Credit default swap (CDS)
• Total return swap
• Constant maturity credit default swap (CMCDS)
• First to Default Credit Default Swap
• Portfolio Credit Default Swap
• Secured Loan Credit Default Swap
• Credit Default Swap on Asset Backed Securities
• Credit default swaption
• Recovery lock transaction
• Credit Spread Option
• CDS index products
Funded credit derivative products include the following products:
• Credit linked note (CLN)
• Synthetic Collateralised Debt Obligation (CDO)
• Constant Proportion Debt Obligation (CPDO)
• Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)
Credit derivative 51

Key unfunded credit derivative products

Credit default swap

The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product
represents over thirty percent of the credit derivatives market[3] .
A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract
between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a
third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate
to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfill certain pre-agreed
characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment
by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.
The relevant credit events specified in a transaction will usually be selected from amongst the following:
• The bankruptcy of the reference entity;
• Its failure to pay in relation to a covered obligation;
• It defaulting on an obligation or that obligation being accelerated;
• It agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered
If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the
credit event as well as (usually) providing some publicly available information validating this claim, then the
transaction will settle.
This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the
reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that
they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will
be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its
current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness).
Credit default swaps have unique characteristics that distinguish them from insurance products and financial
guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The
protection buyer does not need to suffer a loss.
Since the reference entity is not a party to agreement between the protection buyer and seller, the seller of protection
has no inherent recourse to the reference entity in the event of default and no right to sue the reference entity for
recovery. However, if the transaction were to be physically settled the seller of protection could derive a right to take
action against the reference entity on the basis of the loan or securities acquired during the settlement process.
The product has many variations, including where there is a basket or portfolio of reference entities, although
fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late:
credit default swaps which relate to asset-backed securities[7] .

Total return swap

A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby
they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest
payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other
receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as
with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may
be any asset, index or basket of assets.
The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use
of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to
ownership of a credit asset.
Credit derivative 52

The essential difference between a total return swap and a credit default swap is that the credit default swap provides
protection against specific credit events. The total return swap protects against the loss of value irrespective of cause,
whether default, widening of credit spreads or anything else i.e. it isolates both credit risk and market risk.

Key funded credit derivative products

Credit linked notes

A credit linked note is a note whose

cash flow depends upon an event,
which may be a default, change in
credit spread, or rating change. The
definition of the relevant credit events
must be negotiated by the parties to the
A CLN in effect combines a
credit-default swap with a regular note
(with coupon, maturity, redemption).
Given its note like features, a CLN is
an on-balance-sheet asset, in contrast
to a CDS.
In this example coupons from the bank's portfolio of loans are passed to the SPV which
Typically, an investment fund manager uses the cash flow to service the credit linked notes.
will purchase such a note to hedge
against possible down grades, or loan defaults.
Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. Here
we are going to provide an overview rather than a detailed account of these instruments.
The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a
less creditworthy risk.
For example, a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that
country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its
exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from
the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank
runs into difficulty, their investments will suffer even if the country is still performing well.
The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an
enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.
There are several different types of securitized product, which have a credit dimension. CLN is a generic name
related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through
the use of a credit derivative, but does not have to be.
• Credit-linked notes CLN: Credit-linked note is a generic name related to any bond whose value is linked to the
performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not
have to be.
• Collateralized debt obligation CDO: Generic term for a bond issued against a mixed pool of assets - There also
exists CDO-squared (CDO^2) where the underlying assets are CDO tranches.
• Collateralized bond obligations CBO: Bond issued against a pool of bond assets or other securities. It is referred
to in a generic sense as a CDO
Credit derivative 53

• Collateralized loan obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense
as a CDO
CDO refers either to the pool of assets used to support the CLNs or, confusingly, to the CLNs themselves.

Collateralized debt obligations (CDO)

Collateralized debt obligations (CDOs) are a form of credit derivative offering exposure to a large number of
companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is
known as a tranche.
In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic
CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO.
Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche.
These CDOs are commonly known as CDOs-squared.

Pricing of credit derivative is not an easy process. This is because:
• The complexity in monitoring the market price of the underlying credit obligation.
• Understanding the creditworthiness of a debtor is often a cumbersome task as it is not easily quantifiable.
• The incidence of default is not a frequent phenomenon and makes it difficult for the investors to find the
empirical data of a solvent company with respect to default.
• Even though one can take help of different ratings published by ranking agencies but often these ratings will be

Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve
issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations
for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they
exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the
people who know most about them also typically have a vested incentive in encouraging their growth and lack of
regulation. incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in
keeping open doors for research.)

Notes and references

[1] Das, Satyajit (2005). Credit Derivatives: CDOs and Structured Credit Products, 3rd Edition. Wiley. ISBN 978-0-470-82159-6.
[2] "PLC Finance Practice Note: Credit Derivatives by Edmund Parker" (http:/ / www. mayerbrown. com/ london/ article. asp?id=4234&
nid=1575). .
[3] "British Banker Association Credit Derivatives Report" (http:/ / www. bba. org. uk/ content/ 1/ c4/ 76/ 71/
Credit_derivative_report_2006_exec_summary. pdf) (PDF). .
[4] "ISDA" (http:/ / www. isda. org). .
[5] http:/ / www. isda. org
[6] Hosking, Patrick; Costello, Miles; Leroux, Marcus (September 16, 2008). "Dow dives as Federal Reserve lines up 75bn emergency loan for
AIG" (http:/ / business. timesonline. co. uk/ tol/ business/ industry_sectors/ banking_and_finance/ article4761839. ece). The Times (London). .
Retrieved April 30, 2010.
[7] "Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer Brown" (http:/ / www. mayerbrown.
com/ london/ article. asp?id=3517& nid=1575). .
Credit derivative 54

External links
• A Credit Derivatives Risk Primer (http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html)
- Simplified explanation for lay persons.
• The Lehman Brothers Guide to Exotic Credit Derivatives (http://www.investinginbonds.com/assets/files/
• The J.P. Morgan Guide to Credit Derivatives (http://www.investinginbonds.com/assets/files/
• History of Credit Derivatives, Financial-edu.com (http://www.financial-edu.com/history-of-credit-derivatives.
• A Beginner's Guide to Credit Derivatives - Noel Vaillant, Nomura International (http://www.probability.net/
• Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer Brown,
Euromoney Handbooks (http://www.mayerbrown.com/london/article.asp?id=3517&nid=1575).

Equity derivative
In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more
underlying equity securities. Options and futures are by far the most common equity derivatives, however there are
many other types of equity derivatives that are actively traded.

Equity options
Equity options are the most common type of equity derivative.[1] They provide the right, but not the obligation, to
buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a
certain period of time (prior to the expiration date).

In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified
price, which is much lower than the stock price at time of issue. Warrants are frequently attached to bonds or
preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to
enhance the yield of the bond, and make them more attractive to potential buyers.

Convertible bonds
Convertible bonds are bonds that can be converted into shares of stock in the issuing company, usually at some
pre-announced ratio. It is a hybrid security with debt- and equity-like features. It can be used by investors to obtain
the upside of equity-like returns while protecting the downside with regular bond-like coupons.
Equity derivative 55

Equity futures, options and swaps

Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single
stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the
price of the underlying stock or stocks.

Stock market index futures

Stock market index futures are futures contracts used to replicate the performance of an underlying stock market
index. They can be used for hedging against an existing equity position, or speculating on future movements of the
index. Indices for futures include well-established indices such as S&P, FTSE, DAX, CAC40 and other G12 country
indices. Indices for OTC products are broadly similar, but offer more flexibility.

Equity basket derivatives

Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. They
have similar characteristics to equity index derivatives, but are always traded OTC (over the counter, ie between
established institutional investors), as the basket definition is not standardized in the way that an equity index is.
These are used normally for correlation trading.

Single-stock futures
Single-stock futures are exchange-traded futures contracts based on an individual underlying security rather than a
stock index. Their performance is similar to that of the underlying equity itself, although as futures contracts they are
usually traded with greater leverage. Another difference is that holders of long positions in single stock futures
typically do not receive dividends and holders of short positions do not pay dividends. Single-stock futures may be
cash-settled or physically settled by the transfer of the underlying stocks at expiration, although in the United States
only physical settlement is used to avoid speculation in the market....

Equity index swaps

An equity index swap is an agreement between two parties to swap two sets of cash flows on predetermined dates for
an agreed number of years. The cash flows will be an equity index value swapped, for instance, with LIBOR. Swaps
can be considered as being a relatively straightforward way of gaining exposure to an asset class you require. They
can also be relatively cost efficient.

Equity swap
An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows. In
this case the cash flows will be the price of an underlying stock value swapped, for instance, with LIBOR. A typical
example of this type of derivative is the Contract for difference (CFD) where one party gains exposure to a share
price without buying or selling the underlying share making it relatively cost efficient as well as making it relevantly
easy to transact.
Equity derivative 56

Exchange-traded derivatives
Other examples of equity derivative securities include exchange-traded funds and Intellidexes.

[1] Investopedia.com—Equity derivatives (http:/ / www. investopedia. com/ terms/ e/ equity_derivative. asp)

Warrant (finance)

Investment fund
Structured finance
Agency security

Bond market
Stock market
Futures market
Foreign exchange market
Commodity market
Spot market
Over-the-counter market (OTC)

Bonds by coupon
Fixed rate bond
Floating rate note
Zero-coupon bond
Inflation-indexed bond
Commercial paper
Perpetual bond

Bonds by issuer
Corporate bond
Government bond
Municipal bond
Sovereign bond

Equities (stocks)
Initial public offering (IPO)
Short selling
Warrant (finance) 57

Investment funds
Mutual fund
Index fund
Exchange-traded fund (ETF)
Closed-end fund
Segregated fund
Hedge fund

Structured finance
Asset-backed security
Mortgage-backed security
Commercial mortgage-backed
Residential mortgage-backed security
Collateralized debt obligation
Collateralized fund obligation
Collateralized mortgage obligation
Credit-linked note
Unsecured debt
Agency security

Forward contract
Credit derivative
Hybrid security

In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a
fixed exercise price until the expiry date.
Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to
buy securities. Both are discretionary and have expiration dates. The word warrant simply means to "endow with the
right", which is only slightly different to the meaning of an option.
Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest
rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential
buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable, and can be sold
independently of the bond or stock.
In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they
can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so
the investor can earn dividends.
Warrants are actively traded in some financial markets such as Deutsche Börse and Hong Kong.[1] In Hong Kong
Stock Exchange, warrants accounted for 11.7% of the turnover in the first quarter of 2009, just second to the callable
bull/bear contract.[2]
Warrant (finance) 58

Structure and features

Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:
• Exercising: A warrant is exercised when the holder informs the issuer their intention to purchase the shares
underlying the warrant.
The warrant parameters, such as exercise price, are fixed shortly after the issue of the bond. With warrants, it is
important to consider the following main characteristics:
• Premium: A warrant's "premium" represents how much extra you have to pay for your shares when buying them
through the warrant as compared to buying them in the regular way.
• Gearing (leverage): A warrant's "gearing" is the way to ascertain how much more exposure you have to the
underlying shares using the warrant as compared to the exposure you would have if you buy shares through the
• Expiration Date: This is the date the warrant expires. If you plan on exercising the warrant you must do so before
the expiration date. The more time remaining until expiry, the more time for the underlying security to appreciate,
which, in turn, will increase the price of the warrant (unless it depreciates). Therefore, the expiry date is the date
on which the right to exercise no longer exists.
• Restrictions on exercise: Like options, there are different exercise types associated with warrants such as
American style (holder can exercise anytime before expiration) or European style (holder can only exercise on
expiration date).[3]
Warrants are longer-dated options and are generally traded over-the-counter.

Secondary market
Sometimes the issuer will try to establish a market for the warrant and to register it with a listed exchange. In this
case, the price can be obtained from a broker. But often, warrants are privately held or not registered, which makes
their prices less obvious. Warrants can be easily tracked by adding a "w" after the company’s ticker symbol to check
the warrant's price. Unregistered warrant transactions can still be facilitated between accredited parties, and in fact
several secondary markets have been formed to provide liquidity for these investments.

Comparison with call options

Warrants are very similar to call options. For instance, many warrants confer the same rights as equity options, and
warrants often can be traded in secondary markets like options. However, there also are several key differences
between warrants and equity options:
• Warrants are issued by private parties, typically the corporation on which a warrant is based, rather than a public
options exchange.
• Warrants issued by the company itself are dilutive. When the warrant issued by the company is exercised, the
company issues new shares of stock, so the number of outstanding shares increases. When a call option is
exercised, the owner of the call option receives an existing share from an assigned call writer (except in the case
of employee stock options, where new shares are created and issued by the company upon exercise). Unlike
common stock shares outstanding, warrants do not have voting rights.
• Warrants are considered over the counter instruments, and thus are usually only traded by financial institutions
with the capacity to settle and clear these types of transactions.
• A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months.
Even LEAPS (long-term equity anticipation securities), the longest stock options available, tend to expire in two
or three years. Upon expiration, the warrants are worthless unless the price of the common stock is greater than
the exercise price.
Warrant (finance) 59

• Warrants are not standardized like exchange-listed options. While investors can write stock options on the ASX
(or CBOE), they are not permitted to do so with ASX-listed warrants, since only companies can issue warrants,
and while each option contract is over 1000 underlying ordinary shares (100 on CBOE), the number of warrants
that must be exercised by the holder to buy the underlying asset depends on the conversion ratio set out in the
offer documentation for the warrant issue.

Types of warrants
A wide range of warrants and warrant types are available. The reasons you might invest in one type of warrant may
be different from the reasons you might invest in another type of warrant.
• Equity warrants: Equity warrants can be call and put warrants.
• Callable warrants: give you the right to buy the underlying securities
• Putable warrants: give you the right to sell the underlying securities
• Covered warrants: A covered warrants is a warrant that has some underlying backing, for example the issuer will
purchase the stock beforehand or will use other instruments to cover the option.
• Basket warrants: As with a regular equity index, warrants can be classified at, for example, an industry level.
Thus, it mirrors the performance of the industry.
• Index warrants: Index warrants use an index as the underlying asset. Your risk is dispersed—using index call and
index put warrants—just like with regular equity indexes. It should be noted that they are priced using index
points. That is, you deal with cash, not directly with shares.
• Wedding warrants: are attached to the host debentures and can be exercised only if the host debentures are
• Detachable warrants: the warrant portion of the security can be detached from the debenture and traded
• Naked warrants: are issued without an accompanying bond, and like traditional warrants, are traded on the stock

Traditional warrants are issued in conjunction with a Bond (known as a warrant-linked bond), and represent the right
to acquire shares in the entity issuing the bond. In other words, the writer of a traditional warrant is also the issuer of
the underlying instrument. Warrants are issued in this way as a "sweetener" to make the bond issue more attractive,
and to reduce the interest rate that must be offered in order to sell the bond issue.

• Price paid for bond with warrants
• Coupon payments C
• Maturity T
• Required rate of return r
• Face value of bond F

Value of warrants =
Warrant (finance) 60

Naked warrants are issued without an accompanying bond, and like traditional warrants, are traded on the stock
exchange. They are typically issued by banks and securities firms. These are also called covered warrants, and are
settled for cash, e.g. do not involve the company who issues the shares that underlie the warrant. In most markets
around the world, covered warrants are more popular than the traditional warrants described above. Financially they
are also similar to call options, but are typically bought by retail investors, rather than investment funds or banks,
who prefer the more keenly priced options which tend to trade on a different market. Covered warrants normally
trade alongside equities, which makes them easier for retail investors to buy and sell them.

Third-party warrants
Third-party warrant is a derivative issued by the holders of the underlying instrument. Suppose a company issues
warrants which give the holder the right to convert each warrant into one share at $500. This warrant is
company-issued. Suppose, a mutual fund that holds shares of the company sells warrants against those shares, also
exercisable at $500 per share. These are called third-party warrants. The primary advantage is that the instrument
helps in the price discovery process. In the above case, the mutual fund selling a one-year warrant exercisable at
$500 sends a signal to other investors that the stock may trade at $500-levels in one year. If volumes in such
warrants are high, the price discovery process will be that much better; for it would mean that many investors believe
that the stock will trade at that level in one year. Third-party warrants are essentially long-term call options. The
seller of the warrants does a covered call-write. That is, the seller will hold the stock and sell warrants against them.
If the stock does not cross $500, the buyer will not exercise the warrant. The seller will, therefore, keep the warrant

Traded warrants
• "Traditional" warrant
• Naked warrant
• Exotic warrant
• Barrier warrant
• Covered warrant
• Hit-warrant
• Turbo warrant
• Snail warrant
• Third party warrants

There are various methods (models) of evaluation available to value warrants theoretically, including the
Black-Scholes evaluation model. However, it is important to have some understanding of the various influences on
warrant prices. The market value of a warrant can be divided into two components:
• Intrinsic value: This is simply the difference between the exercise (strike) price and the underlying stock price.
Warrants are also referred to as in-the-money or out-of-the-money, depending on where the current asset price is
in relation to the warrant's exercise price. Thus, for instance, for call warrants, if the stock price is below the strike
price, the warrant has no intrinsic value (only time value—to be explained shortly). If the stock price is above the
strike, the warrant has intrinsic value and is said to be in-the-money.
• Time value: Time value can be considered as the value of the continuing exposure to the movement in the
underlying security that the warrant provides. Time value declines as the expiry of the warrant gets closer. This
erosion of time value is called time decay. It is not constant, but increases rapidly towards expiry. A warrant's
Warrant (finance) 61

time value is affected by the following factors:

• Time to expiry: The longer the time to expiry, the greater the time value of the warrant. This is because the
price of the underlying asset has a greater probability of moving in-the-money which makes the warrant more
• Volatility: The more volatile the underlying instrument, the higher the price of the warrant will be (as the
warrant is more likely to end up in-the-money).
• Dividends: To include the factor of receiving dividends depends on if the holder of the warrant is permitted to
receive dividends from the underlying asset.
• Interest rates: An increase in interest rates will lead to more expensive call warrants and cheaper put warrants.
The level of interest rates reflects the opportunity cost of capital.

• Portfolio protection: Put warrants allow the owner to protect the value of the owner's portfolio against falls in the
market or in particular shares.
• Low cost
• Leverage

There are certain risks involved in trading warrants—including time decay. Time decay: "Time value" diminishes as
time goes by—the rate of decay increases the closer to the date of expiration.

Uses of the term warrant other than as an option on equities

Warrant as a check or IOU issued by a government agency
The term warrant is sometimes used in the US to mean a warrant of payment which is a check or an IOU issued by a
governmental agency. California differentiates between normal warrants, which can be exchanged immediately for
cash and registered warrants which are IOUs.[4]
In the late 1990s, when the State of California had a budget crisis due to a disagreement between the governor and
the legislature, the state treasurer was forced to issue warrants paying 18% interest in lieu of being able to pay the
state's bills with real money. The state had not issued warrants since before the Depression of the 1930s. Many
institutions accepted them at face value because of the interest provision. Interestingly, the comptroller of Los
Angeles County was buying the warrants because the county had surplus funds to take advantage of the higher
interest rates on the warrants.
In some states, a warrant is a demand draft drawn on a government's treasury to pay its bills. Checks or electronic
payments have replaced these warrants, but in Arkansas, some counties and school districts uses warrants for
non-electronic payments
Warrant (finance) 62

[1] (http:/ / www. sfc. hk/ sfc/ doc/ EN/ research/ research/ rs paper 13. pdf)
[2] (http:/ / paper. wenweipo. com/ 2009/ 04/ 02/ FI0904020009. htm)
[3] Warrants on Wikinvest
[4] Frequently Asked Questions about Registered Warrants (IOUs) (http:/ / www. sco. ca. gov/ 5935. html)

• Incademy (http://www.incademy.com/training/Covered-Warrants-I/Introduction/1087/10002/)
• Investopedia (http://www.investopedia.com/terms/w/warrant.asp)
• Invest-FAQ (http://invest-faq.com/articles/stock-warrants.html)
• Basics of Financial Management, 3rd ed. Frank Bacon, Tai S. Shin, Suk H. Kim, Ramesh Garg. Copley
Publishing Company. Action, Mass., 2004.
• Special Situation Investing: Hedging, Arbitrage, and Liquidation, Brian J. Stark, Dow-Jones Publishers. New
York, NY, 1983. ISBN 0-87094-384-7; ISBN 978-0-87094-384-3.
• Warrants on Wikinvest

External links
• Chicago Board Options Exchange (http://www.cboe.com/)
• Finance glossary by SGCIB (http://www.equityderivatives.com/services/education/glossary.php?code=W)
• Warrants traded in Hong Kong (http://www.quamnet.com/marketwarrantsindex.action)—Information on
warrant products traded in Hong Kong
• Covered warrants from Societe Generale in the UK (http://uk.warrants.com/)
• Covered warrants from Royal Bank of Scotland in the UK (http://ukmarkets.rbs.com/EN/Showpage.
• Covered Search (http://www.borntosell.com/search)
• Canadian Stock Warrants (http://canadianwarrants.com/values/current.htm)
Foreign exchange option 63

Foreign exchange option

In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative
financial instrument where the owner has the right but not the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange rate on a specified date.[1]
The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of
the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the
International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on
futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for
International Settlements at $158,300 billion in 2005.

For example a GBPUSD FX option might be specified by a contract giving the owner the right but not the obligation
to sell £1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is
2.0000 USD per GBP (or 0.5000 GBP per USD) and the notionals are £1,000,000 and $2,000,000.
This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market
participants, as it is a put on the exchange rate; it could equally be called a USDGBP call, but market convention is
quote GBPUSD (USD per GBP).
If the rate is lower than 2.0000 come December 31 (say at 1.9000), meaning that the dollar is stronger and the pound
is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back
in the spot market at 1.9000, making a profit of (2.0000 GBPUSD - 1.9000 GBPUSD)*1,000,000 GBP = 100,000
USD in the process. If they immediately exchange their profit into GBP this amounts to 100,000/1.9000 = 52,631.58

Generally in thinking about options, one assumes that one is buying an asset: for instance, you can have a call option
on oil, which allows you to buy oil at a given price. One can consider this situation more symmetrically in FX, where
one exchanges: a put on GBPUSD allows one to exchange GBP for USD: it is at once a put on GBP and a call on
As a vivid example: people usually consider that in a fast food restaurant, one buys hamburgers and pays in dollars,
but one can instead say that the restaurant buys dollars and pays in hamburgers.
There are a number of subtleties that follow from this symmetry.
Ratio of notionals
The ratio of the notionals in an FX option is the strike, not the current spot or forward. Notably, when
constructing an option strategy from FX options, one must be careful to match the foreign currency notionals,
not the local currency notionals, else the foreign currencies received and delivered don't offset and one is left
with residual risk.
Non-linear payoff
The payoff for a vanilla option is linear in the underlying, when one denominates the payout in a given
numéraire. In the case of an FX option on a rate, one must be careful of which currency is the underlying and
which is the numéraire: in the above example, an option on GBPUSD gives a USD value that is linear in
GBPUSD (a move from 2.0000 to 1.9000 yields a .10 * $2,000,000 / 2.0000 = $100,000 profit), but has a
non-linear GBP value. Conversely, the GBP value is linear in the USDGBP rate, while the USD value is
non-linear. This is because inverting a rate has the effect of , which is non-linear.
Foreign exchange option 64

Change of numéraire
The implied volatility of an FX option depends on the numéraire of the purchaser, again because of the
non-linearity of .

Hedging with FX options

Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is
to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.
Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering
equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm will
lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken
against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash
flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for
GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly
matches the firm's exposure, perfectly hedging their FX risk.
If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the
expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite
Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected
income for pounds sterling at a predetermined rate), which will:
• protect the GBP value that the firm will receive in 90 day's time (presuming the cash is received)
• cost at most the option premium (unlike a forward, which can have unlimited losses)
• yield a profit if the expected cash is not received but FX rates move in its favor

Valuing FX options: The Garman-Kohlhagen model

As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of a
European option on an FX rate is typically calculated by assuming that the rate follows a log-normal process.
In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates
(one for each currency). Suppose that is the risk-free interest rate to expiry of the domestic currency and is
the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of
the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of
domestic currency per unit of foreign currency").
Then the domestic currency value of a call option into the foreign currency is

The value of a put option has value

where :

is the current spot rate

is the strike price
is the cumulative normal distribution function
is domestic risk free simple interest rate
Foreign exchange option 65

is foreign risk free simple interest rate

is the time to maturity (calculated according to the appropriate day count convention)
and is the volatility of the FX rate.

Risk Management
Garman-Kohlhagen (GK) is the standard model used to calculate the price of an FX option, however there are a wide
range of techniques in use for calculating the options risk exposure, or Greeks (as for example the Vanna-Volga
method). Although the price produced by every model will agree, the risk numbers calculated by different models
can vary significantly depending on the assumptions used for the properties of the spot price movements, volatility
surface and interest rate curves.
After GK, the most common models in use are SABR and local volatility, although when agreeing risk numbers with
a counterparty (e.g. for exchanging delta, or calculating the strike on a 25 delta option) the Garman-Kohlhagen
numbers are always used.

[1] " Foreign Exchange (FX) Terminologies: Forward Deal and Options Deal (http:/ / au. ibtimes. com/ articles/ 111913/ 20110213/
foreign-exchange-fx-terminologies-forward-deal-and-options-deal. htm)" Published by the International Business Times AU (http:/ / au.
ibtimes. com/ forex) on February 14, 2011.

Gold as an investment
Of all the precious metals, gold is the most popular as an investment.[1]
Investors generally buy gold as a hedge or safe haven against any
economic, political, social, or fiat currency crises (including
investment market declines, burgeoning national debt, currency failure,
inflation, war and social unrest). The gold market is also subject to
speculation as other commodities are, especially through the use of Reserves of SDR, forex and gold in 2006
futures contracts and derivatives. The history of the gold standard, the
role of gold reserves in central banking, gold's low correlation with
other commodity prices, and its pricing in relation to fiat currencies
during the financial crisis of 2007–2010, suggest that gold has features
of being money.[2] [3]

Gold price
Gold has been used throughout history as money and has been a
relative standard for currency equivalents specific to economic regions
or countries. Many European countries implemented gold standards in
A Good Delivery bar, the standard for trade in the
the later part of the 19th century until these were dismantled in the major international gold markets.
financial crises involving World War I. After World War II, the
Bretton Woods system pegged the United States dollar to gold at a rate of US$35 per troy ounce. The system existed
until the 1971 Nixon Shock, when the US unilaterally suspended the direct convertibility of the United States dollar
to gold and made the transition to a fiat currency system. The last currency to be divorced from gold was the Swiss
Franc in 2000.
Gold as an investment 66

Since 1919 the most common benchmark for the price of gold has been the London gold fixing, a twice-daily
telephone meeting of representatives from five bullion-trading firms of the London bullion market. Furthermore,
gold is traded continuously throughout the world based on the intra-day spot price, derived from over-the-counter
gold-trading markets around the world (code "XAU"). The following table sets forth the gold price versus various
assets and key statistics:

Year [4] [5] [7] [8]

Gold USD/ozt DJIA USD World US Debt USD bn Trade Weighted US dollar Index
USD tn

1970 37 839 3.3 370

1975 140 852 6.4 533 33.0

1980 590 964 11.8 908 35.7

1985 327 1,547 13.0 1,823 68.2

1990 391 2,634 22.2 3,233 73.2

1995 387 5,117 29.8 4,974 90.3

2000 273 10,787 31.9 5,662 118.6

2005 513 10,718 45.1 8,170 111.6

2010 1,410 11,578 ... 14,025 99.9

1970 to 2010 net change, %

3,792 1,280 ... 3,691 ...

1975 (post US off gold standard) to 2010 net change, %

929 1,259 ... 2,531 ...

In March 2008, the gold price exceeded US$1,000,[9] achieving a nominal high of US$1,004.38. In real terms, actual
value was still well below the US$599 peak in 1981 (equivalent to $1417 in U.S. 2008 dollar value). After the March
2008 spike, gold prices declined to a low of US$712.30 per ounce in November. Pricing soon resumed on upward
momentum by temporarily breaking the US$1000 barrier again in late February 2009 but regressed moderately later
in the quarter.
Later in 2009, the March 2008 intra-day spot price record of US$1,033.90 was broken several times in October, as
the price of gold entered parabolic stages of successively new highs when a spike reversal to $1226 initiated a retrace
of the price to the mid-October levels.
On November 9, 2010, gold closed at a new nominal high of $1421.00 in NYMEX.[10]

Factors influencing the gold price

Today, like most commodities, the price of gold is driven by supply and demand as well as speculation. However
unlike most other commodities, saving and disposal plays a larger role in affecting its price than its consumption.
Most of the gold ever mined still exists in accessible form, such as bullion and mass-produced jewelry, with little
value over its fine weight — and is thus potentially able to come back onto the gold market for the right price.[11] [12]
At the end of 2006, it was estimated that all the gold ever mined totalled 158000 tonnes ( LT; ST).[13] This can be
represented by a cube with an edge length of 20.2 metres (66 ft).
Given the huge quantity of gold stored above-ground compared to the annual production, the price of gold is mainly
affected by changes in sentiment, rather than changes in annual production.[14] According to the World Gold
Council, annual mine production of gold over the last few years has been close to 2,500 tonnes.[15] About 2,000
tonnes goes into jewellery or industrial/dental production, and around 500 tonnes goes to retail investors and
Gold as an investment 67

exchange traded gold funds.[15]

Central banks
Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004
central banks and official organizations held 19 percent of all above-ground gold as official gold reserves.[16] The ten
year Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members
(Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to
less than 500 tonnes a year.[17] European central banks, such as the Bank of England and Swiss National Bank, were
key sellers of gold over this period.[18] In 2009, this agreement was extended for a further five years, but with a
smaller annual sales limit of 400 tonnes.[19]
Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed
interest in growing their gold reserves again as of late 2005.[20] In early 2006, China, which only holds 1.3% of its
reserves in gold,[21] announced that it was looking for ways to improve the returns on its official reserves. Some
bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central
Banks. India has recently purchased over 200 tons of gold which has led to a surge in prices.[22]

Hedge against financial stress

Gold, like all precious metals, may be used as a hedge against inflation, deflation or currency devaluation. As Joe
Foster, portfolio manager of the New York-based Van Eck International Gold Fund, explained in September 2010:
The currencies of all the major countries, including ours, are under severe pressure because of massive
government deficits. The more money that is pumped into these economies – the printing of money basically
– then the less valuable the currencies become.[23]
If the return on bonds, equities and real estate is not adequately compensating for risk and inflation then the demand
for gold and other alternative investments such as commodities increases. An example of this is the period of
stagflation that occurred during the 1970s and which led to an economic bubble forming in precious metals.[24] [25]

Jewelery and industrial demand

Jewelery consistently accounts for over two-thirds of annual gold demand. India is the largest consumer in volume
terms, accounting for 27% of demand in 2009, followed by China and the USA.[26]
Industrial, dentistry and medical uses account for around 12% of gold demand. Gold has high thermal and electrical
conductivity properties, along with a high resistance to corrosion and bacterial colonization. Jewelery and industrial
demand has fluctuated over the past few years due to the steady expansion in emerging markets of middle classes
aspiring to Western lifestyles, offset by the financial crisis of 2007–2010.[27]

Short selling
The price of gold is also affected by various well-documented mechanisms of artificial price suppression, arising
from fractional-reserve banking and naked short selling in gold, and particularly involving the London Bullion
Market Association, the United States Federal Reserve System, and the banks HSBC and JPMorgan Chase.[28] [29]
[30] [31]
Gold market observers have noted for many years that the price of gold tends to fall artificially at the start of
New York trading.[32]
Gold as an investment 68

War, invasion and national emergency

When dollars were fully convertible into gold via the gold standard, both were regarded as money. However, most
people preferred to carry around paper banknotes rather than the somewhat heavier and less divisible gold coins. If
people feared their bank would fail, a bank run might result. This happened in the USA during the Great Depression
of the 1930s, leading President Roosevelt to impose a national emergency and issue Executive Order 6102 outlawing
the ownership of gold by US citizens.[33] There was only one prosecution under the order, and in that case the order
was ruled invalid by federal judge John M. Woolsey, on the technical grounds that the order was signed by the
President, not the Secretary of the Treasury as required.[34]
In times of war, people fear that their assets may be seized and that the currency may become worthless. They see
gold as a solid asset which will always buy food or transportation. Thus in times of great uncertainty, particularly
when war is feared, the demand for gold rises.[35] [36]

Investment vehicles

The most traditional way of investing in gold is by buying bullion gold
bars. In some countries, like Canada Argentina, Austria, Liechtenstein
and Switzerland, these can easily be bought or sold at the major banks.
Alternatively, there are bullion dealers that provide the same service.
Bars are available in various sizes. For example in Europe, Good
Delivery bars are approximately 400 troy ounces (12 kg).[37]
1 kilogram (32 ozt) are also popular, although many other weights
exist, such as the 10oz, 1oz, 10 g, 100 g, 1 kg, 1 Tael, and 1 Tola.

Bars generally carry lower price premiums than gold bullion coins. 1 troy ounce (31 g) gold bar with certificate
However larger bars carry an increased risk of forgery due to their less
stringent parameters for appearance. While bullion coins can be easily weighed and measured against known values,
most bars cannot, and gold buyers often have bars re-assayed. Larger bars also have a greater volume in which to
create a partial forgery using a tungsten-filled cavity, which may not be revealed by an assay.[38]
Efforts to combat gold bar counterfeiting include kinebars which employ a unique holographic technology and are
manufactured by the Argor-Heraeus refinery in Switzerland.

Gold coins are a common way of owning gold. Bullion coins are priced
according to their fine weight, plus a small premium based on supply
and demand (as opposed to numismatic gold coins which are priced
mainly by supply and demand based on rarity and condition).
The Krugerrand is the most widely-held gold bullion coin, with
46000000 troy ounces (1400 tonnes) in circulation. Other common
The faces of a Krugerrand, the most common
gold bullion coins include the Australian Gold Nugget (Kangaroo),
gold bullion coin.
Austrian Philharmoniker (Philharmonic), Austrian 100 Corona,
Canadian Gold Maple Leaf, Chinese Gold Panda, Malaysian Kijang
Emas, French Coq d’Or (Golden Rooster), Mexican Gold 50 Peso, British Sovereign, and American Gold Eagle.

Coins may be purchased from a variety of dealers both large and small. Fake gold coins are not uncommon, and are
usually made of gold-plated lead.
Gold as an investment 69

Exchange-traded products (ETPs)

Gold exchange-traded products may include ETFs, ETNs, and CEFs which are traded like shares on the major stock
exchanges. The first gold ETF, Gold Bullion Securities (ticker symbol "GOLD"), was launched in March 2003 on
the Australian Stock Exchange, and originally represented exactly 0.1 troy ounces (3.1 g) of gold. As of November
2010, SPDR Gold Shares is the second-largest exchange-traded fund (ETF) in the world by market capitalization.[39]
Gold ETPs represent an easy way to gain exposure to the gold price, without the inconvenience of storing physical
bars. However exchange-traded gold instruments, even those which hold physical gold for the benefit of the investor,
carry risks beyond those inherent in the precious metal itself. For example the most popular gold ETP (GLD) has
been widely criticized, and even compared with mortgage-backed securities, due to features of its complex
structure.[28] [40] [41] [42] [43]
Typically a small commission is charged for trading in gold ETPs and a small annual storage fee is charged. The
annual expenses of the fund such as storage, insurance, and management fees are charged by selling a small amount
of gold represented by each certificate, so the amount of gold in each certificate will gradually decline over time.
Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-end companies or Unit
Investment Trusts (UITs), but that differ from traditional open-end companies and UITs.[44] The main differences are
that ETFs do not sell directly to investors and they issue their shares in what are called "Creation Units" (large blocks
such as blocks of 50,000 shares). Also, the Creation Units may not be purchased with cash but a basket of securities
that mirrors the ETF's portfolio. Usually, the Creation Units are split up and re-sold on a secondary market.
ETF shares can be sold in basically two ways. The investors can sell the individual shares to other investors, or they
can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors
the securities that comprise the portfolio instead of cash. Because of the limited redeemability of ETF shares, ETFs
are not considered to be and may not call themselves mutual funds.[44]

Gold certificates allow gold investors to avoid the risks and costs associated with the transfer and storage of physical
bullion (such as theft, large bid-offer spread, and metallurgical assay costs) by taking on a different set of risks and
costs associated with the certificate itself (such as commissions, storage fees, and various types of credit risk).
Banks may issue gold certificates for gold which is allocated (non-fungible) or unallocated (fungible or pooled).
Unallocated gold certificates are a form of fractional reserve banking and do not guarantee an equal exchange for
metal in the event of a run on the issuing bank's gold on deposit.[45] Allocated gold certificates should be correlated
with specific numbered bars, although it is difficult to determine whether a bank is improperly allocating a single bar
to more than one party.[46]
The first paper bank notes were gold certificates. They were first issued in the 17th century when they were used by
goldsmiths in England and The Netherlands for customers who kept deposits of gold bullion in their vault for
safe-keeping. Two centuries later, the gold certificates began being issued in the United States when the US Treasury
issued such certificates that could be exchanged for gold. The United States Government first authorized the use of
the gold certificates in 1863. In the early 1930s the US Government restricted the private gold ownership in the
United States and therefore, the gold certificates stopped circulating as money. Nowadays, gold certificates are still
issued by gold pool programs in Australia and the United States, as well as by banks in Germany and Switzerland.
Gold as an investment 70

Many types of gold "accounts" are available. Different accounts impose varying types of intermediation between the
client and their gold. One of the most important differences between accounts is whether the gold is held on an
allocated (non-fungible) or unallocated (fungible) basis. Another major difference is the strength of the account
holder's claim on the gold, in the event that the account administrator faces gold-denominated liabilities (due to a
short or naked short position in gold for example), asset forfeiture, or bankruptcy.
Many banks offer gold accounts where gold can be instantly bought or sold just like any foreign currency on a
fractional reserve (non-allocated, fungible) basis. Swiss banks offer similar service on an allocated (non-fungible)
basis. Pool accounts, such as those offered by Kitco, facilitate highly liquid but unallocated claims on gold owned by
the company. Digital gold currency systems operate like pool accounts and additionally allow the direct transfer of
fungible gold between members of the service. BullionVault and Anglo Far-East allow clients to create a bailment
on allocated (non-fungible) gold, which becomes the legal property of the buyer.

Derivatives, CFDs and spread betting

Derivatives, such as gold forwards, futures and options, currently trade on various exchanges around the world and
over-the-counter (OTC) directly in the private market. In the U.S., gold futures are primarily traded on the New York
Commodities Exchange (COMEX) and Euronext.liffe. In India, gold futures are traded on the National Commodity
and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX).[47]
As of 2009, holders of COMEX gold futures have experienced problems taking delivery of their metal. Along with
chronic delivery delays, some investors have received delivery of bars not matching their contract in serial number
and weight. The delays cannot be easily explained by slow warehouse movements, as the daily reports of these
movements show little activity. Because of these problems, there are concerns that COMEX may not have the gold
inventory to back its existing warehouse receipts.[48]
Firms such as Cantor Index, CMC Markets, IG Index and City Index, all from the UK, provide contract for
difference (CFD) or spread bets on the price of gold.

Mining companies
These do not represent gold at all, but rather are shares in gold mining companies. If the gold price rises, the profits
of the gold mining company could be expected to rise and as a result the share price may rise. However, there are
many factors to take into account and it is not always the case that a share price will rise when the gold price
increases. Mines are commercial enterprises and subject to problems such as flooding, subsidence and structural
failure, as well as mismanagement, theft and corruption. Such factors can lower the share prices of mining
The price of gold bullion is volatile, but unhedged gold shares and funds are regarded as even higher risk and even
more volatile. This additional volatility is due to the inherent leverage in the mining sector. For example, if you own
a share in a gold mine where the costs of production are $300 per ounce and the price of gold is $600, the mine's
profit margin will be $300. A 10% increase in the gold price to $660 per ounce will push that margin up to $360,
which represents a 20% increase in the mine's profitability, and potentially a 20% increase in the share price.
Furthermore, at higher prices, more ounces of gold become economically viable to mines, enabling companies to add
to their reserves. Conversely, share movements also amplify falls in the gold price. For example, a 10% fall in the
gold price to $540 will decrease that margin to $240, which represents a 20% fall in the mine's profitability, and
potentially a 20% decrease in the share price.
To reduce this volatility, some gold mining companies hedge the gold price up to 18 months in advance. This
provides the mining company and investors with less exposure to short term gold price fluctuations, but reduces
returns when the gold price is rising.
Gold as an investment 71

Investment strategies

Fundamental analysis
Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic
indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also
analyze the yearly global gold supply versus demand. Over 2005 the World Gold Council estimated yearly global
gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes.[49] While gold
production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and
subject to rapid changes. This makes gold very different from almost every other commodity.[11] [12] Identifiable
investment demand for gold, which includes gold exchange-traded funds, bars and coins, was up 64 percent in 2008
over the year before.[50]

Gold versus stocks

In the last century, major economic crises
(such as the Great Depression, World War
II, the first and second oil crisis) lowered the
Dow/gold ratio, an indicator of how bad a
recession is and whether the outlook is
deteriorating or improving, to a value well
below 4. The ratio fell on February 18, 2009
to below 8.[50] During these difficult times,
many investors tried to preserve their assets
by investing in precious metals, most
notably gold and silver.

The performance of gold bullion is often

compared to stocks due to their fundamental
differences. Gold is regarded by some as a Dow/Gold Ratio 1968-2008
store of value (without growth) whereas
stocks are regarded as a return on value (i.e., growth from anticipated real price increase plus dividends). Stocks and
bonds perform best in a stable political climate with strong property rights and little turmoil. The attached graph
shows the value of Dow Jones Industrial Average divided by the price of an ounce of gold. Since 1800, stocks have
consistently gained value in comparison to gold in part because of the stability of the American political system.[51]
This appreciation has been cyclical with long periods of stock outperformance followed by long periods of gold
outperformance. The Dow Industrials bottomed out a ratio of 1:1 with gold during 1980 (the end of the 1970s bear
market) and proceeded to post gains throughout the 1980s and 1990s. The gold price peak of 1980 also coincided
with the Soviet Union's invasion of Afghanistan and the threat of the global expansion of communism. The ratio
peaked on January 14, 2000 a value of 41.3 and has fallen sharply since.

On November 30, 2005, Rick Munarriz of The Motley Fool posed the question of which represented a better
investment: a share of Google or an ounce of gold. The specific comparison between these two very different
investments seems to have captured the imagination of many in the investment community and is serving to
crystallize the broader debate.[52] [53] At the time of writing, a share of Google's stock was $405 and an ounce of gold
was one day from breaking the $500 barrier, which it did December 1. On January 4, 2008 23:58 New York Time, it
was reported that an ounce of gold outpaced the share price of Google by 30.77%, with gold closing at $859.19 per
ounce and a share of Google closing at $657 on U.S. market exchanges. On January 24, 2008, the gold price broke
the $900 mark per ounce for the first time. The price of gold topped $1,000 an ounce for the first time ever on March
Gold as an investment 72

13, 2008 amid recession fears in the United States.[54] Google closed 2008 at $307.65 while gold closed the year at
$866. Leading into 2010, Google had doubled off that (100%), whereas gold had risen 40%.
Note that the analysis of log-linear oscillations in the gold price dynamics for 2003–2010 conducted recently by
Askar Akayev's research group has allowed them to forecast a collapse in gold prices in April – June 2011.[55]

Technical analysis
As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis.
Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order
to speculate on the future price.

Using leverage
Bullish investors may choose to leverage their position by borrowing money against their existing assets and then
purchasing gold on account with the loaned funds. Leverage is also an integral part of buying gold derivatives and
unhedged gold mining company shares (see gold mining companies). Leverage or derivatives may increase
investment gains but also increases the corresponding risk of capital loss if/when the trend reverses.

Gold maintains a special position in the market with many tax regimes. For example, in the European Union the
trading of recognised gold coins and bullion products are free of VAT. Silver, and other precious metals or
commodities, do not have the same allowance. Other taxes such as capital gains tax may also apply for individuals
depending on their tax residency. U.S. citizens may be taxed on their gold profits at 15, 23, 28 or 35 percent,
depending on the investment vehicle used.[56]
USA: Due to section 9006 of the U.S. Patient Protection and Affordable Care Act, starting on January 1, 2012, IRS
tax form 1099 will be required for all purchases of goods and services that exceed $600 per calendar year. This new
reporting requirement will cover precious metals. With gold at $1200 per ounce, this would make it impossible to
sell a typical one-ounce bullion coin without IRS paperwork. As of July 2010 the bullion industry is fighting the
regulation, and California Representative Dan Lungren has introduced legislation to have the relevant section of the
Act reversed.[57]

Scams and frauds

Gold attracts its fair share of fraudulent activity. Some of the most common to be aware of are:
• High-yield investment programs - HYIPs are usually just pyramid schemes dressed up with no real value
underneath. Using gold in their prospectus makes them seem more solid and trustworthy.
• Advance fee fraud - Various emails circulate on the Internet for buyers or sellers of up to 10,000 metric tonnes of
gold. This is more gold than the US Federal Reserve owns. Often naive middlemen are drafted in as hopeful
brokers, and usually mention mythical terms like 'Swiss Procedure' or 'FCO' (Full Corporate Offer). The
end-game of these scams is unknown, but they probably just attempt to extract a small 'validation' sum out of the
innocent buyer/seller from their hope of getting the big deal.[58]
• Gold dust sellers - This scam persuades an investor there is real gold with a trial quantity, then eventually delivers
brass filings or similar.
• Counterfeit gold coins.
• Shares in fraudulent mining companies with no gold reserves, or potential of finding gold,[59] as per the American
saying, attributed to Mark Twain but unsourced, that "A gold mine is a hole in the ground with a liar on top."[60]
• Cash for gold - With the rise in the value of gold due to the financial crisis of 2007-2010, there has been a surge
in companies that will buy personal gold in exchange for cash, or sell investments in gold bullion and coins.
Gold as an investment 73

Several of these have prolific marketing plans and high value spokesmen, such as prior vice presidents. Many of
these companies are under investigation for a variety of securities fraud claims, as well as laundering money for
terrorist organizations.[61] [62] [63] [64] Also given that ownership is often not verified, many companies are
considered to be receiving stolen property, and multiple laws are under consideration on methods to curtail
this.[65] [66]

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Gold as an investment 75

External links
• GoldPrice.org (http://www.goldprice.org/) (quick current price)
The History of Gold by Goldcore.com (http://www.goldcore.com/research/history_gold)
• (Gold) kinebars (http://www.kbwealthgroup.com) (detailed information on kinebars & gold)
• Gold as an investment (http://www.dmoz.org/Business/Investing/Commodities_and_Futures/
Precious_Metals/Gold/) at the Open Directory Project

Credit default swap

A credit default swap (CDS) is a swap
contract and agreement in which the
protection buyer of the CDS makes a series
of payments (often referred to as the CDS
"fee" or "spread") to the protection seller
and, in exchange, receives a payoff if a
credit instrument (typically a bond or loan)
experiences a credit event. It is a form of
reverse trading.

In its simplest form, a credit default swap is

a bilateral contract between the buyer and
seller of protection. The CDS will refer to a
"reference entity" or "reference obligor",
usually a corporation or government. The
reference entity is not a party to the contract. If the reference bond performs without default, the protection buyer pays quarterly
payments to the seller until maturity
The protection buyer makes quarterly
premium payments—the "spread"—to the
protection seller. If the reference entity
defaults, the protection seller pays the buyer
the par value of the bond in exchange for
physical delivery of the bond, although
settlement may also be by cash or auction.[1]
A default is referred to as a "credit event"
and includes such events as failure to pay,
restructuring and bankruptcy.[2] Most CDSs
are in the $10–$20 million range with
maturities between one and 10 years.[3]

A holder of a bond may “buy protection” to

hedge its risk of default. In this way, a CDS
is similar to credit insurance, although CDS
are not similar to or subject to regulations
If the reference bond defaults, the protection seller pays par value of the bond to
governing casualty or life insurance. Also, the buyer, and the buyer physically delivers the bond to the seller
investors can buy and sell protection without
Credit default swap 76

owning any debt of the reference entity. These “naked credit default swaps” allow traders to speculate on debt issues
and the creditworthiness of reference entities. Credit default swaps can be used to create synthetic long and short
positions in the reference entity.[4] Naked CDS constitute most of the market in CDS.[5] [6] In addition, credit default
swaps can also be used in capital structure arbitrage.
Credit default swaps have existed since the early 1990s, but the market increased tremendously starting in 2003. By
the end of 2007, the outstanding amount was $62.2 trillion, falling to $38.6 trillion by the end of 2008.[7]
Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives
Association (ISDA), although some are tailored to meet specific needs. Credit default swaps have many variations.[2]
In addition to the basic, single-name swaps, there are basket default swaps (BDS), index CDS, funded CDS (also
called a credit linked notes), as well as loan only credit default swaps (LCDS). In addition to corporations or
governments, the reference entity can include a special purpose vehicle issuing asset backed securities.[8]
Credit default swaps are not traded on an exchange and there is no required reporting of transactions to a government
agency.[9] During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the
trillion dollar size of the market, which could pose a systemic risk to the economy.[2] [4] [10] In March 2010, the
DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators
greater access to its credit default swaps database.[11]


- Buyer purchased a CDS at time t0 and makes regular premium payments at times t1, t2,
t3, and t4. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t5,

t6 and so on until the end of the contract at time tn. - However, if the associated credit
instrument suffered a credit event at t5, then the Protection seller pays the buyer for the loss, and the buyer would
cease paying premiums.
A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic
payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a
similar credit event.[1] [2] [12] The CDS may refer to a specified loan or bond obligation of a “reference entity”,
usually a corporation or government.[3]
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The
investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky
Corp defaults on its debt, the investor will receive a one-time payment from AAA-Bank, and the CDS contract is
terminated. A default is referred to as a "credit event" and include such events as failure to pay, restructuring and
bankruptcy.[2] [9] CDS contracts on sovereign obligations also usually include as credit events repudiation,
moratorium and acceleration.[9]
If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also buy
CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for
speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money if it fails, or to hedge
investments in other companies whose fortunes are expected to be similar to those of Risky (see Uses).
Credit default swap 77

If the reference entity (Risky Corp) defaults, one of two kinds of settlement can occur:
• the investor delivers a defaulted asset to AAA-Bank for payment of the par value, which is known as physical
• AAA-Bank pays the investor the difference between the par value and the market price of a specified debt
obligation (even if Risky Corp defaults there is usually some recovery, i.e. not all your money will be lost), which
is known as cash settlement.
The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the
contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis
points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank
must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp
defaults. Payments are usually made on a quarterly basis, in arrears.
Credit default swaps are not retail transactions. Most CDS’s are in the $10–20 million range with maturities between
one and 10 years.[3] Five years is the most typical maturity.[8]
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS
associated with a company with a higher CDS spread is considered more likely to default by the market, since a
higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss
given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference
obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs
having to perform under these contracts.[2]

Not insurance
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum
of money if one of the events specified in the contract occurs. However, there are a number of differences between
CDS and insurance, for example:
• The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the
buyer does not even have to suffer a loss from the default event.[13] [14] [15] [16] In contrast, to purchase insurance,
the insured is generally expected to have an insurable interest such as owning a debt obligation;
• the seller doesn't have to be a regulated entity;
• the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to
bank capital requirements;
• insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS
manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying
bond markets;
• in the United States CDS contracts are generally subject to mark-to-market accounting, introducing income
statement and balance sheet volatility that would not be present in an insurance contract;
• Hedge accounting may not be available under US Generally Accepted Accounting Principles (GAAP) unless the
requirements of FAS 133 [17] are met. In practice this rarely happens.
However the most important difference between CDS and insurance is simply that an insurance contract provides an
indemnity against the losses actually suffered by the policy holder, whereas the CDS provides an equal payout to all
holders, calculated using an agreed, market-wide method.
There are also important differences in the approaches used to pricing. The cost of insurance is based on actuarial
analysis. CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with
other credit market instruments such as loans and bonds from the same 'Reference Entity' to which the CDS contract
Credit default swap 78

Further, to cancel the insurance contract the buyer can simply stop paying premium whereas in case of CDS the
protection buyer may need to unwind the contract which might result in a profit or loss situation
Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement. Most
significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to
guarantee payment of claims.

When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk:[2] [8]
• The buyer takes the risk that the seller will default. If AAA-Bank and Risky Corp. default simultaneously
("double default"), the buyer loses its protection against default by the reference entity. If AAA-Bank defaults but
Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.
• The seller takes the risk that the buyer will default on the contract, depriving the seller of the expected revenue
stream. More important, a seller normally limits its risk by buying offsetting protection from another party — that
is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the
hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a
lower price than the original CDS and may therefore involve a loss to the seller.
In the future, in the event that regulatory reforms require that CDS be traded and settled via a central
exchange/clearing house, such as ICE TCC, there will no longer be 'counterparty risk', as the risk of the counterparty
will be held with the central exchange/clearing house.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or both parties to
a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional
collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may
vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of
the parties changes.
Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk.[2] A seller of a CDS
could be collecting monthly premiums with little expectation that the reference entity may default. A default creates
a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers.[18] This
risk is not present in other over-the-counter derivatives.[2] [18]

Sources of market data

Data about the credit default swaps market is available from three main sources. Data on an annual and semiannual
basis is available from the International Swaps and Derivatives Association (ISDA) since 2001[19] and from the
Bank for International Settlements (BIS) since 2004.[20] The Depository Trust & Clearing Corporation (DTCC),
through its global repository Trade Information Warehouse (TIW), provides weekly data but publicly available
information goes back only one year.[21] The numbers provided by each source do not always match because each
provider uses different sampling methods.[2]
According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually
all CDS contracts outstanding in the marketplace."[22]
The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S
commercial banks and trust companies.[23]
Credit default swap 79

Credit default swaps can be used by investors for speculation, hedging and arbitrage.

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices
such as the North American CDX index or the European iTraxx index. An investor might believe that an entity's
CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by
entering into a trade, known as a basis trade, that combines a CDS with a cash bond and an interest-rate swap.
Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads will increase as
credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS
protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it
thinks that the company's creditworthiness might improve. The investor selling the CDS is viewed as being “long” on
the CDS and the credit, as if the investor owned the bond.[4] [8] In contrast, the investor who bought protection is
“short” on the CDS and the underlying credit.[4] [8] Credit default swaps opened up important new avenues to
speculators. Investors could go long on a bond without any upfront cost of buying a bond; all the investor need do
was promise to pay in the event of default.[24] Shorting a bond faced difficult practical problems, such that shorting
was often not feasible; CDS made shorting credit possible and popular.[8] [24] Because the speculator in either case
does not own the bond, its position is said to be a synthetic long or short position.[4]
For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $10 million
worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500
basis points (=5%) per annum.
• If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid $500,000 to
AAA-Bank, but will then receive $10 million (assuming zero recovery rate, and that AAA-Bank has the liquidity
to cover the loss), thereby making a profit. AAA-Bank, and its investors, will incur a $9.5 million loss minus
recovery unless the bank has somehow offset the position before the default.
• However, if Risky Corp does not default, then the CDS contract will run for two years, and the hedge fund will
have ended up paying $1 million, without any return, thereby making a loss. AAA-Bank, by selling protection,
has made $1 million without any upfront investment.
Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a
certain period of time in an attempt to realise its gains or losses. For example:
• After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread has widened from
500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of protection for 1 year to
AAA-Bank at this higher rate. Therefore over the two years the hedge fund will pay the bank 2 * 5% *
$10 million = $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000.
• In another scenario, after one year the market now considers Risky much less likely to default, so its CDS spread
has tightened from 500 to 250 basis points. Again, the hedge fund may choose to sell $10 million worth of
protection for 1 year to AAA-Bank at this lower spread. Therefore over the two years the hedge fund will pay the
bank 2 * 5% * $10 million = $1 million, but will receive 1 * 2.5% * $10 million = $250,000, giving a total loss of
$750,000. This loss is smaller than the $1 million loss that would have occurred if the second transaction had not
been entered into.
Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS spread had
widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an
offsetting contract immediately and made a small profit over the life of the two CDS contracts.
Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning
bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those
Credit default swap 80

assets through the use of CDS.[25] CDOs are viewed as complex and opaque financial instruments. An example of a
synthetic CDO is Abacus 2007-AC1 which is the subject of the civil suit for fraud brought by the SEC against
Goldman Sachs in April 2010.[26] Abacus is a synthetic CDO consisting of credit default swaps referencing a variety
of mortgage backed securities.
Naked credit default swaps. In the examples above, the hedge fund did not own debt of Risky Corp. A CDS in
which the buyer does not own the underlying debt is referred to as a naked credit default swap, estimated to be up to
80% of the credit default swap market.[5] [6] There is currently a debate in the United States and Europe about
whether speculative uses of credit default swaps should be banned. Legislation is under consideration by Congress as
part of financial reform.[6]
Critics assert that naked CDS should be banned, comparing them to buying fire insurance on your neighbor’s house,
which creates a huge incentive for arson. Analogizing to the concept of insurable interest, critics say you should not
be able to buy a CDS—insurance against default—when you do not own the bond.[27] [28] [29] Short selling is also
viewed as gambling and the CDS market as a casino.[6] [30] Another concern is the size of CDS market. Because
naked credit default swaps are synthetic, there is no limit to how many can be sold. The gross amount of CDS far
exceeds all “real” corporate bonds and loans outstanding.[9] [28] As a result, the risk of default is magnified leading to
concerns about systemic risk.[28]
Financier George Soros called for an outright ban on naked credit default swaps, viewing them as “toxic” and
allowing speculators to bet against and “bear raid” companies or countries.[31] His concerns were echoed by several
European politicians who, during the Greek Financial Crisis, accused naked CDS buyers as making the crisis
worse.[32] [33]
Despite these concerns, Secretary of Treasury Geithner[6] [32] and Commodity Futures Trading Commission
Chairman Gensler[34] are not in favor of an outright ban of naked credit default swaps. They prefer greater
transparency and better capitalization requirements.[6] [18] These officials think that naked CDS have a place in the
Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps,
options or futures, has the beneficial effect of increasing liquidity in the marketplace.[27] That benefits hedging
activities. Without speculators buying and selling naked CDS, banks wanting to hedge might not find a ready seller
of protection.[6] [27] Speculators also create a more competitive marketplace, keeping prices down for hedgers. A
robust market in credit default swaps can also serve as a barometer to regulators and investors about the credit health
of a company or country.[27] [35]
Despite politicians' assertions that speculators are making the Greek crisis worse, Germany's market regulator BaFin
found no proof supporting the claim.[33] Some suggest that without credit default swaps, Greece’s borrowing costs
would be higher.[33]

Credit default swaps are often used to manage the risk of default which arises from holding debt. A bank, for
example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of
protection. If the loan goes into default, the proceeds from the CDS contract will cancel out the losses on the
underlying debt.[3]
There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the loan outright
or bring in other banks as participants. However, these options may not meet the bank’s needs. Consent of the
corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants. If
both the borrower and lender are well-known and the market (or even worse, the news media) learns that the bank is
selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely
damage the banker-client relationship. In addition, the bank simply may not want to sell or share the potential profits
from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its
Credit default swap 81

portfolio.[25] The downside to this hedge is that without default risk, a bank may have no motivation to actively
monitor the loan and the counterparty has no relationship to the borrower.[25]
Another kind of hedge is against concentration risk. A bank’s risk management team may advise that the bank is
overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS.
Because the borrower—the reference entity—is not a party to a credit default swap, entering into a CDS allows the
bank to achieve its diversity objectives without impacting its loan portfolio or customer relations.[2] Similarly, a bank
selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no
customer base.[3] [8] [36]
A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit risk, a bank
is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under
Basel I). This frees resources which the bank can use to make other loans to the same key customer or to other
borrowers.[2] [37]
Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or
insurance companies, may buy a CDS as a hedge for similar reasons. Pension fund example: A pension fund owns
five-year bonds issued by Risky Corp with par value of $10 million. In order to manage the risk of losing money if
Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of
$10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection,
the pension fund pays 2% of $10 million ($200,000) per annum in quarterly installments of $50,000 to Derivative
• If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to
Derivative Bank for 5 years and receives its $10 million back after five years from Risky Corp. Though the
protection payments totaling $1 million reduce investment returns for the pension fund, its risk of loss due to
Risky Corp defaulting on the bond is eliminated.
• If Risky Corporation defaults on its debt three years into the CDS contract, the pension fund would stop paying
the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of
$10 million minus recovery (either by physical or cash settlement — see Settlement below). The pension fund
still loses the $600,000 it has paid over three years, but without the CDS contract it would have lost the entire
$10 million minus recovery.
In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of
similar risks as a proxy for its own credit risk exposure on receivables.[6] [27] [37] [38]
Although credit default swaps have been highly criticized for their role in the recent financial crisis, most observers
conclude that using credit default swaps as a hedging device has a useful purpose.[27]

Capital Structure Arbitrage is an example of an arbitrage strategy that utilizes CDS transactions.[39] This technique
relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e. if the
outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less
likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price
should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market
inefficiencies between different parts of the same company's capital structure; i.e. mis-pricings between a company's
debt and equity. An arbitrageur will attempt to exploit the spread between a company's CDS and its equity in certain
situations. For example, if a company has announced some bad news and its share price has dropped by 25%, but its
CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share
price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while
simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the
CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened
Credit default swap 82

relative to its equity.

An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks
down is during a Leveraged buyout (LBO). Frequently this will lead to the company's CDS spread widening due to
the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a
company usually end up paying a premium.
Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade
closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due
to technical reasons such as:
• Specific settlement differences
• Shortages in a particular underlying instrument
• Existence of buyers constrained from buying exotic derivatives.
The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to
zero. Basis trades can aim to exploit any differences to make risk-free profit.


Forms of credit default swaps had been in existence from at least the early 1990s, [40] with early trades carried out by
Bankers Trust in 1991. [41] J.P. Morgan & Co. is widely credited with creating the modern credit default swap in
1994.[42] [43] [44] In that instance, J.P. Morgan had extended a $4.8 billion credit line to Exxon, which faced the
threat of $5 billion in punitive damages for the Exxon Valdez oil spill. A team of J.P. Morgan bankers led by Blythe
Masters then sold the credit risk from the credit line to the European Bank of Reconstruction and Development in
order to cut the reserves which J.P. Morgan was required to hold against Exxon's default, thus improving its own
balance sheet.[45] In 1997, JPMorgan developed a proprietary product called BISTRO (Broad Index Securitized
Trust Offering) that used CDS to clean up a bank’s balance sheet.[42] [44] The advantage of BISTRO was that it used
securitization to split up the credit risk into little pieces which smaller investors found more digestible, since most
investors lacked EBRD's capability to accept $4.8 billion in credit risk all at once. BISTRO was the first example of
what later became known as synthetic collateralized debt obligations (CDOs).
Mindful of the concentration of default risk as one of the causes of the S&L crisis , regulators initially found CDS's
ability to disperse default risk attractive. [41] In 2000, credit default swaps became largely exempt from regulation by
both the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission
(CTFC). The Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole ,
specifically stated that CDSs are neither futures nor securities and so are outside the remit of the SEC and CTFC.

Market growth
At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in connection with
its lending activities. Banks also saw an opportunity to free up regulatory capital. By march 1998, the global market
for CDS was estimated atabout $300 billion, with JP Morgan alone accounting for about $50billion of this. [41] The
high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw
trading opportunities in credit default swaps. By 2002, investors as speculators, rather than banks as hedgers,
dominated the market.[2] [8] [37] [40] National banks in the USA used credit default swaps as early as 1996.[36] In that
year, the Office of the Comptroller of the Currency measured the size of the market as tens of billions of dollars.[46]
Six years later, by year-end 2002, the outstanding amount was over $2 trillion.[7] Although speculators fueled the
exponential growth, other factors also played a part. An extended market could not emerge until 1999, when ISDA
standardized the documentation for credit default swaps.[47] [48] [49] Also, the 1997 Asian Financial Crisis spurred a
Credit default swap 83

market for CDS in emerging market sovereign debt.[49] In addition, in 2004, index trading began on a large scale and
grew rapidly.[8]
The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003.[7] By the
end of 2007, the CDS market had a notional value of $62.2 trillion.[7] But notional amount fell during 2008 as a
result of dealer "portfolio compression" efforts (replacing offsetting redundant contracts), and by the end of 2008
notional amount outstanding had fallen 38 percent to $38.6 trillion.[50]
Explosive growth was not without operational headaches. On September 15, 2005, the New York Fed summoned 14
banks to it offices. Billions of dollars of CDS were traded daily but the record keeping was more than two weeks
behind.[51] This created severe risk management issues, as counterparties were in legal and financial limbo.[8] [52]
U.K. authorities expressed the same concerns.[53]

Market as of 2008
Since default is a relatively rare occurrence (historically around 0.2%
of investment grade companies will default in any one year),[54] in
most CDS contracts the only payments are the premium payments
from buyer to seller. Thus, although the above figures for outstanding
notionals are very large, in the absence of default the net cashflows
will only be a small fraction of this total: for a 100 bp = 1% spread, the
annual cash flows are only 1% of the notional amount.

Regulatory concerns over CDS

The market for Credit Default Swaps attracted considerable concern

Composition of the United States 15.5 trillion US
from regulators after a number of large scale incidents in 2008, starting
dollar CDS market at the end of 2008 Q2. Green
with the collapse of Bear Stearns.[55] tints show Prime asset CDSs, reddish tints show
In the days and weeks leading up to Bear's collapse, the bank's CDS sub-prime asset CDSs. Numbers followed by "Y"
indicate years until maturity.
spread widened dramatically, indicating a surge of buyers taking out
protection on the bank. It has been suggested that this widening was
responsible for the perception that Bear Stearns was vulnerable, and
therefore restricted its access to wholesale capital which eventually led
to its forced sale to JP Morgan in March. An alternative, unsupported
view is that this surge in CDS protection buyers was a symptom rather
than a cause of Bear's collapse; i.e., investors saw that Bear was in
trouble, and sought to hedge any naked exposure to the bank, or
speculate on its collapse.

In September, the bankruptcy of Lehman Brothers caused a total close

to $400 billion to become payable to the buyers of CDS protection
referenced against the insolvent bank. However the net amount that
changed hands was around $7.2 billion[56] This difference is due to the Proportion of CDSs nominals (lower left) held by
United States banks compared to all derivatives,
process of 'netting'. Market participants co-operated so that CDS sellers
in 2008Q2. The black disc represents the 2008
were allowed to deduct from their payouts the inbound funds due to public debt.
them from their hedging positions. Dealers generally attempt to remain
risk-neutral so their losses and gains after big events will on the whole offset each other.

Also in September American International Group (AIG) required a federal bailout because it had been excessively
selling CDS protection without hedging against the possibility that the reference entities might decline in value,
which exposed the insurance giant to potential losses over $100 billion. The CDS on Lehman were settled smoothly,
Credit default swap 84

as was largely the case for the other 11 credit events occurring in 2008 which triggered payouts.[55] And while it is
arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used
for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk
involved in CDS transactions.
In 2008 there was no centralized exchange or clearing house for CDS transactions; they were all done over the
counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation.[57] In
November, DTCC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total
market,[58] announced that it will release market data on the outstanding notional of CDS trades on a weekly
basis.[59] The data can be accessed on the DTCC's website here:[60] The U.S. Securities and Exchange Commission
granted an exemption for IntercontinentalExchange to begin guaranteeing credit-default swaps.
The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger
competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John Nester said he didn’t
know when a decision would be made.

Market as of 2009
The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from concerns over
the instruments' safety after the events of the previous year. According to Deutsche Bank managing director
Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few months" By late 2008
processes had been introduced allowing CDSs which offset each other to be cancelled. Along with termination of
contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of
the market down to an estimated $30 trillion.[61] The Bank for International Settlements estimates that outstanding
derivatives total $592 trillion.[62] U.S. and European regulators are developing separate plans to stabilize the
derivatives market. Additionally there are some globally agreed standards falling into place in March 2009,
administered by International Swaps and Derivatives Association (ISDA). Two of the key changes are:
1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the
central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and
seller face.
2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the
payout should be is unclear.
Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York,

A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. ... Trading will be much easier.... We'll see
new players come to the market because they’ll like the idea of this being a better and more traded product. We also feel like over time we'll
see the creation of different types of products. ”
In the U.S., central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key
competitor also interested in entering the CDS clearing sector is CME Group.
In Europe, CDS Index clearing was launched by ICE's European subsidiary ICE Clear Europe on July 31. It
launched Single Name clearing in Dec 2009. By the end of 2009, it had cleared CDS contracts worth EUR
885 billion reducing the open interest down to EUR 75 billion [63]
By the end of 2009, banks had reclaimned much of their market share; hedge funds had largely retreated from the
market after the crises. According to an estimate by the Banque de France, by late 2009 the bank JP Morgan alone
now had about 30% of the global CDS market. [41]
Credit default swap 85

Government approvals relating to Intercontinental and its competitor CME

The SEC's approval for ICE's request to be exempted from rules that would prevent it clearing CDSs was the third
government action granted to Intercontinental in one week. On March 3, its proposed acquisition of Clearing Corp., a
Chicago clearinghouse owned by eight of the largest dealers in the credit-default swap market, was approved by the
Federal Trade Commission and the Justice Department. On March 5, the Federal Reserve Board, which oversees the
clearinghouse, granted a request for ICE to begin clearing.
Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received
$39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50
profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps.
SEC spokesperson John Nestor stated

For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties....
We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its
exemptive requests. ”
Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd.
Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been
cleared by the NYSE’s London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan

Clearing house member requirements

Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a credit rating
of A or better to clear their credit-default swap trades. Intercontinental said in the statement today that all market
participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as
long as they meet these requirements.
A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty
defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded,
participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators
to view traders’ positions and prices.

Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as
published by the International Swaps and Derivatives Association.[65] The confirmation typically specifies a
reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference
obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection
extends is defined by the contract effective date and scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to successors
and substitute reference obligations (for example necessary if the original reference obligation was a loan that is
repaid before the expiry of the contract), and for performing various calculation and administrative functions in
connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer
is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the
calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has
occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly
available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal
mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the
courts if necessary, though actual instances of specific events being disputed are relatively rare.
Credit default swap 86

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller
and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the
reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North
American investment grade corporate reference entities, European corporate reference entities and sovereigns
generally also include restructuring as a credit event, whereas trades referencing North American high yield
corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially
intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates
changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is
restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent
debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising
out of Conseco's restructuring in 2000 led to the credit event's removal from North American high yield trades.[66]
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that
a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics
vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or
loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer
restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency
before becoming due.
The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling on
March 20, June 20, September 20, and December 20. Due to the proximity to the IMM dates, which fall on the third
Wednesday of these months, these CDS maturity dates are also referred to as "IMM dates".


Physical or cash
As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash
• Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt
obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a
bank on the senior debt of a company. In the event of a default, the bank will pay the hedge fund $5 million cash,
and the hedge fund must deliver $5 million face value of senior debt of the company (typically bonds or loans,
which will typically be worth very little given that the company is in default).
• Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a
debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from
a bank on the senior debt of a company. This company has now defaulted, and its senior bonds are now trading at
25 (i.e. 25 cents on the dollar) since the market believes that senior bondholders will receive 25% of the money
they are owed once the company is wound up. Therefore, the bank must pay the hedge fund $5 million *
(100%-25%) = $3.75 million.
The development and growth of the CDS market has meant that on many companies there is now a much larger
outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. (This is because
many parties made CDS contracts for speculative purposes, without actually owning any debt for which they wanted
to insure against default.) For example, at the time it filed for bankruptcy on September 14, 2008, Lehman Brothers
had approximately $155 billion of outstanding debt[67] but around $400 billion notional value of CDS contracts had
been written which referenced this debt.[68] Clearly not all of these contracts could be physically settled, since there
was not enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash
settled CDS trades. The trade confirmation produced when a CDS is traded will state whether the contract is to be
physically or cash settled.
Credit default swap 87

When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction (also known
as a credit-fixing event) may be held to facilitate settlement of a large number of contracts at once, at a fixed cash
settlement price. During the auction process participating dealers (e.g., the big investment banks) submit prices at
which they would buy and sell the reference entity's debt obligations, as well as net requests for physical settlement
against par. A second stage Dutch auction is held following the publication of the initial mid-point of the dealer
markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of
this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as
matched limit offers resulting from the auction are actually settled. According to the International Swaps and
Derivatives Association (ISDA), who organised them, auctions have recently proved an effective way of settling the
very large volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington
Below is a list of the auctions that have been held since 2005.[70]

Date Name Final price as a percentage of par

2005-06-14 Collins & Aikman - Senior 43.625

2005-06-23 Collins & Aikman - Subordinated 6.375

2005-10-11 Northwest Airlines 28

2005-10-11 Delta Airlines 18

2005-11-04 Delphi Corporation 63.375

2006-01-17 Calpine Corporation 19.125

2006-03-31 Dana Corporation 75

2006-11-28 Dura - Senior 24.125

2006-11-28 Dura - Subordinated 3.5

2007-10-23 Movie Gallery 91.5

2008-02-19 Quebecor World 41.25

2008-10-02 Tembec Inc 83

2008-10-06 Fannie Mae - Senior 91.51

2008-10-06 Fannie Mae - Subordinated 99.9

2008-10-06 Freddie Mac - Senior 94

2008-10-06 Freddie Mac - Subordinated 98

2008-10-10 Lehman Brothers 8.625

2008-10-23 Washington Mutual 57

2008-11-04 Landsbanki - Senior 1.25

2008-11-04 Landsbanki - Subordinated 0.125

2008-11-05 Glitnir - Senior 3

2008-11-05 Glitnir - Subordinated 0.125

2008-11-06 Kaupthing - Senior 6.625

2008-11-06 Kaupthing - Subordinated 2.375

2008-12-09 Masonite [71] - LCDS 52.5

2008-12-17 Hawaiian Telcom - LCDS 40.125

Credit default swap 88

2009-01-06 Tribune - CDS 1.5

2009-01-06 Tribune - LCDS 23.75

2009-01-14 Republic of Ecuador 31.375

2009-02-03 Millennium America Inc 7.125

2009-02-03 Lyondell - CDS 15.5

2009-02-03 Lyondell - LCDS 20.75

2009-02-03 EquiStar 27.5

2009-02-05 Sanitec [72] - 1st Lien 33.5

2009-02-05 Sanitec [72] - 2nd Lien 4.0

2009-02-09 British Vita [73] - 1st Lien 15.5

2009-02-09 British Vita [73] - 2nd Lien 2.875

2009-02-10 Nortel Ltd. 6.5

2009-02-10 Nortel Corporation 12

2009-02-19 Smurfit-Stone CDS 8.875

2009-02-19 Smurfit-Stone LCDS 65.375

2009-02-26 Ferretti 10.875

2009-03-09 Aleris 8

2009-03-31 Station Casinos 32

2009-04-14 Chemtura 15

2009-04-14 Great Lakes 18.25

2009-04-15 Rouse 29.25

2009-04-16 LyondellBasell 2

2009-04-17 Abitibi 3.25

2009-04-21 Charter Communications CDS 2.375

2009-04-21 Charter Communications LCDS 78

2009-04-22 Capmark 23.375

2009-04-23 Idearc CDS 1.75

2009-04-23 Idearc LCDS 38.5

2009-05-12 Bowater 15

2009-05-13 General Growth Properties 44.25

2009-05-27 Syncora 15

2009-05-28 Edshcha 3.75

2009-06-09 HLI Operating Corp LCDS 9.5

2009-06-10 Georgia Gulf LCDS 83

2009-06-11 R.H. Donnelley Corp. CDS 4.875

2009-06-12 General Motors CDS 12.5

2009-06-12 General Motors LCDS 97.5

2009-06-18 JSC Alliance Bank CDS 16.75

Credit default swap 89

2009-06-23 Visteon CDS 3

2009-06-23 Visteon LCDS 39

2009-06-24 RH Donnelley Inc LCDS 78.125

2009-07-09 Six Flags CDS 14

2009-07-09 Six Flags LCDS 96.125

2009-07-21 Lear CDS 38.5

2009-07-21 Lear LCDS 66


2009-11-20 CIT Group Inc. 68.125

Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to
herein as the 'probability model', takes the present value of a series of cashflows weighted by their probability of
non-default. This method suggests that credit default swaps should trade at a considerably lower spread than
corporate bonds.
The second model, proposed by Darrell Duffie, but also by John Hull and White, uses a no-arbitrage approach.

Probability model
Under the probability model, a credit default swap is priced using a model that takes four inputs; this is similar to the
rNPV (risk-adjusted NPV) model used in drug development:
• the "issue premium",
• the recovery rate (percentage of notional repaid in event of default),
• the "credit curve" for the reference entity and
• the "LIBOR curve".
If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments.
So CDS pricing models have to take into account the possibility of a default occurring some time between the
effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a
one year CDS with effective date with four quarterly premium payments occurring at times , , , and .
If the nominal for the CDS is and the issue premium is then the size of the quarterly premium payments is
. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five
ways the contract could end:
• either it does not have any default at all, so the four premium payments are made and the contract survives until
the maturity date, or
• a default occurs on the first, second, third or fourth payment date.
To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value
of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs
multiplied by their probability of occurring.
This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in
which case it ends with a payment of shown in red, where is the recovery rate, or it survives without
a default being triggered, in which case a premium payment of is made, shown in blue. At either side of the
diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the
contract is terminated the square is shown with solid shading.
Credit default swap 90

The probability of surviving over the interval to without a default payment is and the probability of a
default being triggered is . The calculation of present value, given discount factor of to is then

Description Premium Payment PV Default Payment PV Probability

Default at time

Default at time

Default at time

Default at time

No defaults

The probabilities , , , can be calculated using the credit spread curve. The probability of no default
occurring over a time period from to decays exponentially with a time-constant determined by the credit
spread, or mathematically where is the credit spread zero curve at time .
The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.
To get the total present value of the credit default swap we multiply the probability of each outcome by its present
value to give
Credit default swap 91

No-arbitrage model
In the 'no-arbitrage' model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage.
Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both
analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of
the swap on default), which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently
used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can
also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is
70 basis points, then a CDS contract should trade at 30. However there are sometimes technical reasons why this will
not be the case, and this may or may not present an arbitrage opportunity for the canny investor. The difference
between the theoretical model and the actual price of a credit default swap is known as the basis.

Critics of the huge credit default swap market have claimed that it has been allowed to become too large without
proper regulation and that, because all contracts are privately negotiated, the market has no transparency.
Furthermore, there have even been claims that CDSs exacerbated the 2008 global financial crisis by hastening the
demise of companies such as Lehman Brothers and AIG.[74]
In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the
bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS
market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in
serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with
Lehman Brothers to reduce their exposure in the case of their default.
Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the 2009
General Motors Chapter 11 reorganization, because bondholders would benefit from the credit event of a GM
bankruptcy due to their holding of CDSs. Critics speculate that these creditors were incentivized into pushing for the
company to enter bankruptcy protection.[75] Due to a lack of transparency, there was no way to find out who the
protection buyers and protection writers were, and they were subsequently left out of the negotiation process.[76]
It was also reported after Lehman's bankruptcy that the $400 billion notional of CDS protection which had been
written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the
cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further
bankruptcies of firms without enough cash to settle their contracts.[77] However, industry estimates after the auction
suggested that net cashflows would only be in the region of $7 billion.[77] This is because many parties held
offsetting positions; for example if a bank writes CDS protection on a company it is likely to then enter an offsetting
transaction by buying protection on the same company in order to hedge its risk. Furthermore, CDS deals are
marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread
widened, meaning that the net cashflows on the days after the auction are likely to have been even lower.[69] ...
Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis,
Credit default swap 92

but that CDS contracts have been acting to distribute risk just as was intended, and that it is not CDSs themselves
that need further regulation, but the parties who trade them.[78]
Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett famously
described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's
annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their
ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a
contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings
statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the
imagination of man (or sometimes, so it seems, madmen)."[79] To hedge the counterparty risk of entering a CDS
transaction, one practice is to buy CDS protection on one's counterparty. The positions are marked-to-market daily
and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money
does not always change hands due to the offset of gains and losses by those who had both bought and sold
protection. Depository Trust & Clearing Corporation, the clearinghouse for the majority of trades in the US
over-the-counter market, stated in October 2008 that once offsetting trades were considered, only an estimated
$6 billion would change hands on October 21, during the settlement of the CDS contracts issued on Lehman
Brothers' debt, which amounted to somewhere between $150 to $360 billion.[80] Despite Buffett's criticism on
derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it has entered into at least $4.85 billion
in derivative transactions.[81] Buffett stated in his 2008 letter to shareholders that Berkshire Hathaway has no
counterparty risk in its derivative dealings because Berkshire require counterparties to make payments when
contracts are inititated, so that Berkshire always holds the money.[82] Berkshire Hathaway was a large owner of
Moody's stock during the period that it was one of two primary rating agencies for subprime CDOs, a form of
mortgage security derivative dependant on the use of credit default swaps.
The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some
media reports have claimed this was a contributing factor to the downfall of some of the monolines.[83] [84] In 2009
one of the monolines, MBIA, sued Merrill Lynch, claiming that Merill had misrepresented some of its CDOs to
MBIA in order to persuade MBIA to write CDS protection for those CDOs.[85] [86] [87]

Systemic risk
The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because
Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is an example of
systemic risk, risk which threatens an entire market, and a number of commentators have argued that size and
deregulation of the CDS market have increased this risk.
For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in 2005
and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman's default, this
protection was no longer active, and Washington Mutual's sudden default only days later would have led to a
massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman
Brothers and AIG's inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain
of CDS transactions between financial institutions.[88] So far this does not appear to have happened, although some
commentators have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one
could face large losses or possibly even default themselves was a contributing factor to the massive decrease in
lending liquidity during September/October 2008.[89]
Chains of CDS transactions can arise from a practice known as "netting".[90] Here, company B may buy a CDS from
company A with a certain annual "premium", say 2%. If the condition of the reference company worsens, the risk
premium will rise, so company B can sell a CDS to company C with a premium of say, 5%, and pocket the 3%
difference. However, if the reference company defaults, company B might not have the assets on hand to make good
on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to
Credit default swap 93

company C. The problem lies if one of the companies in the chain fails, creating a "domino effect" of losses. For
example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in
bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the
bad debt it held from the reference company. Even worse, because CDS contracts are private, company C will not
know that its fate is tied to company A; it is only doing business with company B.
As described above, the establishment of a central exchange or clearing house for CDS trades would help to solve
the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a
consortium of dealers.

Tax and accounting issues

The U.S federal income tax treatment of credit default swaps is uncertain.[91] Commentators generally believe that,
depending on how they are drafted, they are either notional principal contracts or options for tax purposes,[92] but
this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial
instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the
type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).[93] If a credit default
swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in
ordinary income.[94] If a payment is a termination payment, its tax treatment is even more uncertain.[94] In 2004, the
Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to
taxpayer confusion,[95] but it has not yet issued any guidance on their characterization. A taxpayer must include
income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United
The accounting treatment of Credit Default Swaps used for hedging may not parallel the economic effects and
instead, increase volatility. For example, GAAP generally require that Credit Default Swaps be reported on a mark to
market basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at
cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce
considerable volatility into the income statement and balance sheet as the CDS changes value over its life due to
market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS. One
can try to account for the CDS as a hedge under FASB 133[97] but in practice that can prove very difficult unless the
risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular
CDS that was bought.

A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very similar to a
standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the
Reference Entity rather than the broader category of "Bond or Loan". Also, as of May 22, 2007, for the most widely
traded LCDS form, which governs North American single name and index trades, the default settlement method for
LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same that
has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any
additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007,
the first ever LCDS auction was held for Movie Gallery.[98]
Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond
obligations that are typically assumed to be cheapest to deliver in respect of vanilla CDS, LCDS spreads are
generally much tighter than CDS trades on the same name.
Credit default swap 94

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educat/ faqs. html). . Retrieved March 26, 2010.
[2] Weistroffer, Christian; Deutsche Bank Research (December 21, 2009). "Credit default swaps: Heading towards a more stable system" (http:/ /
www. dbresearch. com/ PROD/ DBR_INTERNET_EN-PROD/ PROD0000000000252032. pdf) (PDF). Deutsche Bank Research: Current
Issues. . Retrieved April 15, 2010.
[3] Federal Reserve Bank of Atlanta (2008-04-14). "Did You Know? A Primer on Credit Default Swaps" (http:/ / www. frbatlanta. org/ pubs/
financialupdate/ financial_update-vol_21_no_2-did_you_know. cfm?redirected=true). Financial update 21 (2). . Retrieved March 31, 2010.
[4] Sirri, Erik, Director, Division of Trading and Markets U.S. Securities and Exchange Commission. "Testimony Concerning Credit Default
Swaps Before the House Committee on Agriculture October 15, 2008" (http:/ / www. sec. gov/ news/ testimony/ 2008/ ts101508ers. htm). .
Retrieved April 2, 2010.
[5] Kopecki, Dawn; Shannon D. Harrington (July 24, 2009). "Banning ‘Naked’ Default Swaps May Raise Corporate Funding Costs" (http:/ /
www. bloomberg. com/ apps/ news?pid=20601208& sid=a0W1VTiv9q2A). Bloomberg. . Retrieved March 31, 2010.
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External links
• Barroso considers ban on speculation with banning purely speculative naked sales on credit default swaps of
sovereign debt (http://www.euractiv.com/en/euro/
• "Systemic Counterparty Confusion: Credit Default Swaps Demystified" (http://derivativedribble.wordpress.
com/2008/10/23/systemic-counterparty-confusion-credit-default-swaps-demystified/). Derivative Dribble.
October 23, 2008.
• CBS '60 minutes' video on CDS (http://www.cbsnews.com/video/watch/?id=4502673n)
• 2003 ISDA Credit Derivatives Template (http://www.isda.org/publications/copyrightspolicy.html).
International Swaps and Derivatives Association
• BIS - Regular Publications (http://www.bis.org/publ/regpubl.htm). Bank for International Settlements.
• A Beginner's Guide to Credit Derivatives (http://www.probability.net/credit.pdf) - Nomura International
• "A billion-dollar game for bond managers" (http://www.ft.com/cms/s/
e463523a-62b4-11db-8faa-0000779e2340.html). Financial Times.
• John C. Hull and Alan White. "Valuing Credit Default Swaps I: No Counterparty Default Risk" (http://www.
rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf). University of Toronto.
• Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations (http://www.
smartquant.com/references/SWAP/swap2.pdf). Smartquant.com
Credit default swap 98

• Elton et al., Explaining the rate spread on corporate bonds (http://pages.stern.nyu.edu/~mgruber/working

• Warren Buffett on Derivatives - Excerpts from the Berkshire Hathaway annual report for 2002. (http://www.
fintools.com/docs/Warren Buffet on Derivatives.pdf) fintools.com
• The Real Reason for the Global Financial Crisis (http://www.financialsense.com/editorials/cooke/2008/1006.
html). Financialsense.com
• Demystifying the Credit Crunch (http://www.privateequitycouncil.org/wordpress/wp-content/uploads/
adl-pe-primer-fin-r2.pdf). Private Equity Council.
• The AIG Bailout (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1346552) William Sjostrom, Jr.
• Standard CDS Pricing Model Source Code (http://www.cdsmodel.com/) - ISDA and Markit. CDSModel.com
• List of CDS premiums of various countries in English translation from German (http://translate.google.com/
• Free Public Access to CDS Clearing Prices (http://www.markit.com/cds) - Markit.

In the news
• Zweig, Phillip L. (July 1997), BusinessWeek New ways to dice up debt - Suddenly, credit derivatives-deals that
spread credit risk--are surging (http://www.businessweek.com/archives/1997/b3536094.arc.htm)
• Goodman, Peter (Oct 2008) New York Times The spectacular boom and calamitous bust in derivatives trading
• Pulliam, Susan and Ng, Serena (January 18, 2008), Wall Street Journal: " Default Fears Unnerve Markets (http://
• Das, Satayjit (February 5, 2008), Financial Times: " CDS market may create added risks (http://www.ft.com/
• Morgenson, Gretchen (February 17, 2008), New York Times: " Arcane Market is Next to Face Big Credit Test
• March 17, 2008 Credit Default Swaps: The Next Crisis? (http://www.time.com/time/business/article/
0,8599,1723152,00.html), Time
• Schwartz, Nelson D. and Creswell, Julie (March 23, 2008), New York Times: " Who Created This Monster? (http:/
• Evans, David (May 20, 2008), Bloomberg: " Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults
• van Duyn, Aline (May 28, 2008), Financial Times: " Moody's issues warning on CDS risks (http://us.ft.com/
• Morgenson, Gretchen (June 1, 2008), New York Times: " First Comes the Swap. Then It’s the Knives. (http://
• Kelleher, James B. (September 18, 2008), Reuters: " Buffett's 'time bomb' goes off on Wall Street. (http://www.
• Morgenson, Gretchen (September 27, 2008), New York Times: " Behind Insurer’s Crisis, Blind Eye to a Web of
Risk (http://www.nytimes.com/2008/09/28/business/28melt.html?em)"
• Varchaver, Nicholas and Benner, Katie (Sep 2008), Fortune Magazine: " The $55 Trillion Question (http://
htm?postversion=2008093012)" - on CDS spotlight during financial crisis.
• Dizard, John (October 23, 2006). "A billion dollar game" (http://us.ft.com/ftgateway/superpage.
ft?news_id=fto102320061114181979). Financial Times. Retrieved October 19, 2008.
Credit default swap 99

• October 19, 2008, Portfolio.com: " Why the CDS Market Didn't Fail (http://www.portfolio.com/views/blogs/
market-movers/2008/10/19/why-the-cds-market-didnt-fail)" Analyzes the CDS market's performance in the
Lehman Bros. bankruptcy.
• Boumlouka, Makrem (April 8, 2009), Wall Street Letter: " Credit Default Swap Market: “Big Bang”? (http://

Equity swap
An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be
exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs"
of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly
referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a
stock market index. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg
vs. an equity leg, although some exist with two equity legs.
An equity swap involves a notional principal, a specified tenor and predetermined payment intervals.
Equity swaps are typically traded by Delta One trading desks.

Parties may agree to make periodic payments or a single payment at the maturity of the swap ("bullet" swap), the
worst case.
Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis points)
against £5,000,000 (FTSE to the £5,000,000 notional). In this case Party A will pay (to Party B) a floating interest
rate (LIBOR +0.03%) on the £5,000,000 notional and would receive from Party B any percentage increase in the
FTSE equity index applied to the £5,000,000 notional.
In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg
payer/equity receiver (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity
payer/floating leg receiver (Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party
B would owe 10%*£5,000,000 = £500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had
fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000
to Party B, since the flow is negative.
For mitigating credit exposure, the trade can be reset, or "marked-to-market" during its life. In that case, appreciation
or depreciation since the last reset is paid and the notional is increased by any payment to the pricing rate payer or
decreased by any payment from the floating leg payer.
Equity swap 100

Typically Equity Swaps are entered into in order to avoid transaction costs (including Tax), to avoid locally based
dividend taxes, limitations on leverage (notably the US margin regime) or to get around rules governing the
particular type of investment that an institution can hold.
Equity Swaps also provide the following benefits over plain vanilla equity investing:
1. An investor in a physical holding of shares loses possession on the shares once he sells his position. However,
using an equity swap the investor can pass on the negative returns on equity position without losing the possession of
the shares and hence voting rights. For example, let's say A holds 100 shares of a Petroleum Company. As the price
of crude falls the investor believes the stock would start giving him negative returns in the short run. However, his
holding gives him a strategic voting right in the board which he does not want to lose. Hence, he enters into an
equity swap deal wherein he agrees to pay Party B the return on his shares against LIBOR+25bps on a notional amt.
If A is proven right, he will get money from B on account of the negative return on the stock as well as
LIBOR+25bps on the notional. Hence, he mitigates the negative returns on the stock without losing on voting rights.
2. It allows an investor to receive the return on a security which is listed in such a market where he cannot invest due
to legal issues. For example, let's say A wants to invest in company X listed in Country C. However, A is not
allowed to invest in Country C due to capital control regulations. He can however, enter into a contract with B, who
is a resident of C, and ask him to buy the shares of company X and provide him with the return on share X and he
agrees to pay him a fixed / floating rate of return.
Equity Swaps, if effectively used, can make investment barriers vanish and help an investor create leverage similar
to those seen in derivative products.
Investment banks that offer this product usually take a riskless position by hedging the client's position with the
underlying asset. For example, the client may trade a swap - say Vodafone. The bank credits the client with 1,000
Vodafone at GBP1.45. The bank pays the return on this investment to the client, but also buys the stock in the same
quantity for its own trading book (1,000 Vodafone at GBP1.45). Any equity-leg return paid to or due from the client
is offset against realised profit or loss on its own investment in the underlying asset. The bank makes its money
through commissions, interest spreads and dividend rake-off (paying the client less of the dividend than it receives
itself). It may also use the hedge position stock (1,000 Vodafone in this example) as part of a funding transaction
such as stock lending,repo or as collateral for a loan.
Property derivatives 101

Property derivatives
A property derivative is a financial derivative whose value is derived from the value of an underlying real estate
asset. In practice, because real estate assets fall victim to market inefficiencies and are hard to accurately price,
property derivative contracts are typically written based on a real estate property index. In turn, the real estate
property index attempts to aggregate real estate market information to provide a more accurate representation of
underlying real estate asset performance. Trading or taking positions in property derivatives is also known as
synthetic real estate.
Property derivatives usually take the form of a total return swap, forward contract, futures, or can adopt a funded
format where the property derivative is embedded into a bond or note structure. Under the total return swap or
forward contract the parties will usually take contrary positions on the price movements of a property index.
The most common benchmarks used for writing property derivative contracts in the UK are the various property
indices published by the Investment Property Databank [1] and FTSE UK Commercial Property Index Series [2]. The
IPD Annual Index covers approximately 12,000 directly held UK property investments, market revalued in
December 2006 at just over £192 billion equivalent to 49% of the UK investment market. IPD indices are also used
in a number of other countries such as Australia, France, Germany, Italy, Japan and Switzerland as the basis for
commercial property derivatives. In the United States commercial property utilizes the National Council of Real
Estate Investment Fiduciaries (NCREIF) property index the NPI. There are two main residential real estate indices in
the United States which trade - Radar Logic's RPX, and the main index - S&P/Case-Shiller Home Price Indices (see
Case-Shiller index).
The FTSE UK Commercial Property Index Series currently covers £16bn of prime investible property assets directly
held in the UK. The FTSE UK Commercial Property Index Series is valued daily, on a T+2 basis.

Uses of Property Derivatives

Property Derivatives provide the investor with the ability to:
• Gain or reduce exposure to the property market.
• Hedge a current position in the physical assets.
• Quickly change the composition of a portfolio, i.e. switch out of Retail property and into Industrial.
• To speculate on the property market
All of these objectives can be achieved without having to transact in physical property; synthetic real estate.

Defining Property Market Performance

To create a derivative there needs to be a point of reference for the performance of the market against which the
derivative contracts are priced.
In the case of property derivatives, this reference is provided by the Investment Property Databank and the FTSE
index in the United Kingdom, and NCREIF, S&P/Case-Shiller and Rexx in the United States.
The IPD Index and the FTSE UK Commercial Property Index Series provide a number of indices which relate to
performance of commercial property. There are many indices reflecting sectors and sub-sectors of the commercial
property market. To date, much of the interest in property derivatives relates to the UK market and its sub-sectors.
Property derivatives 102

Types of Property Derivative

There are 3 main types of Property Derivative in use in the UK property market today: Property Index Notes(PINs),
Total Return Swap (TRS), and Forwards which incorporates the IPD Property Index Futures listed on Eurex.
In the United States property derivative trading is primarily through forwards and future contracts. Forwards
agreements are made generally on the RPX and NCREIF indices. Futures trading is done by the CME Group via
Globex utilizing the S&P/Case-Shiller Home Price Indices.

Property Index Notes

The PINs are essentially bonds. The cash flows of these bonds are structured in a way that is meant to be similar to a
transaction in the physical property. This means that the PIN pays the capital return on redemption of the bond and it
pays a quarterly coupon to investors.
In this way, the seller of the PIN pays the IPD annual or FTSE UK Commercial Property capital growth at
redemption and the income return, paid quarterly (IPD) or monthly (FTSE), to the counter party. This means that the
counter party is, therefore, receiving the total return of the UK commercial property market, just as they would with
a physical transaction in property.

Total Return Swaps

A property total return swap is simply an exchange of cash flows. Here, the total return on property, as measured by
the change in the relevant IPD or FTSE UK Commercial Property Index, is exchanged for the return on cash.
The UK IPD pricing mechanism was simplified on 15 January 2007. Rather than quoting libor +/- a spread, now it’s
a fixed %. So take the Dec 08 contract for example if it has a mid of -11.5%. This means that if you ‘buy’ the swap,
you pay -11.5% (so receive 11.5% due to the -ve sign) to your counterparty and receive the performance of IPD. (Or
pay it out if it’s a negative number) No quarterly cashflows, simply one annual interest payment versus one annual
property payment.

A property forward contract is based upon the property returns in any annual period - the expected total return for
example is agreed at trade, and on maturity the difference between the realized total return and the traded price is
exchanged. Forward agreements are over the counter requiring a counter party to be found. Risk of default of either
party must be considered in the trade [3]
The CME Group has been trading in real estate futures since mid 2006. All trading is done electronically through the
exchange who is the default counter party in all trades [3] .
Since February 2009 Eurex, the international derivatives exchange, has listed Property Index Futures. The Future
Contract is based upon the IPD UK Annual All Property Index Total Returns - the exchange lists five consecutive
annual contracts with pricing based upon a par value of 100 + Expected percentage Total Annual Return in the
related calendar year. The contract for the calendar year 2009, which expired in Mar-10 (expiry is the last working
day in the following March to ensure this is after publication of the IPD data) settled at 103.50, representing a +3.5%
annual total return (as published by IPD). Though a nascent market, in 2010 a total of 3,304 contracts traded
according to the Eurex website - representing £165m in notional property value.
Property derivatives 103

ISDA 2007 Property Index Derivatives Definitions

On Friday 4 May 2007 ISDA released the 2007 Property Index Derivatives Definitions. The definitions set out
various market standard definitions which can be used in property derivatives transactions together with a standard
form total return swap template and forward transaction template[4] It is hoped that standardised documentation will
kick start the market.

External links
• Free information on property derivatives and investment strategies. [5]
• Report on the State of the Sector & Subsector Property Derivatives Market (March 2010) [6]
• 'Trading Property Derivatives'; PDIG - practical tips and advice on how to tackle the issues involved in getting an
organisation to the stage where it can trade derivatives routinely. March 2010 [7]
• 'Getting into Property Derivatives'; PDIG - independent report by market practitioners to support further
development in the understanding of property derivatives, with a particular focus on potential end-users of the
product. updated Feb.2010 [8]
• FTSE Indices for Property Derivatives; FTSE [9]
• Property Derivatives; ICAP Property Derivatives [10]
• Property Derivatives;DTZ Tullet Prebon [11]
• Property Derivatives, A Meaningful Introduction to Property Derivatives [12]
• ISDA’s 2007 Property Index Derivatives Definitions: A Killer Application for the Property Index Derivatives
Market? Edmund Parker [13]
• Property Linked Warrants and Certificates [14]
• Property Derivatives Interest Group (PDIG)- A Special Interest Group of the UK's Investment Property Forum

• Eurex - Property Index Futures [16]

• S&P/Case-Shiller Home Price Index Forecasts [17]
• CB Richard Ellis-GFI Property Derivatives, GFI PropertyMatch trading portal [18]

[1] http:/ / www. ipd. com
[2] http:/ / www. ftse. com/ ukcommercialproperty
[3] Mathers, W.(2010) Synthetic Real Estate Investment for the Small Investor, Charleston
[4] "ISDA’s 2007 Property Index Derivatives Definitions: A Killer Application for the Property Index Derivatives Market?" (http:/ / www.
mayerbrown. com/ london/ article. asp?id=3511& nid=1575). . Retrieved 2008-12-14.
[5] http:/ / www. realmarkits. com/ derivatives/ derivativesindex. html
[6] http:/ / www. hoare-capital. com/ sites/ all/ files/
What%27s%20going%20on%20in%20property%20derivatives%20-%20March%202010%20version. pdf
[7] http:/ / sites. google. com/ site/ pdigdraft/ Home/ trading-property-derivatives-launch
[8] http:/ / sites. google. com/ site/ pdigdraft/ getting-into-property-derivatives-publication-launch
[9] http:/ / www. ftse. com/ Indices/ FTSE_UK_Commercial_Property_Index_Series/ Downloads/
FTSE_Indices_for_Property_Derivatives_0308. pdf
[10] http:/ / www. icappropertyderivatives. com
[11] http:/ / www. dtz. com/ static_files/ Global/ Static%20Files/ PDerivNov07. pdf
[12] http:/ / www. jcra. co. uk/ pdf/ JCRA_PropertyDerivatives. pdf
[13] http:/ / www. mayerbrown. com/ london/ article. asp?id=3511& nid=1575
[14] http:/ / www. tipsheets. co. uk/ Propertylinkedwarrants. pdf
[15] http:/ / www. propertyderivatives. co. uk
[16] http:/ / www. eurexchange. com/ trading/ products/ PRD_en. html
[17] http:/ / www. syntheticrealestateinvestment. com/ home/ property-derivatives
[18] http:/ / www. gfigroup. com/ markets/ commodities/ Property-Europe. aspx
Freight derivative 104

Freight derivative
Freight Derivatives, which includes Forward Freight Agreement (FFA), container freight swap agreements and
options based on these, are financial instruments for trading in future levels of freight rates, for dry bulk carriers,
tankers and containerships. These instruments are settled against various freight rate indices published by the Baltic
Exchange (for Dry and most Wet contracts) & Platt's (Asian Wet contracts). FFAs are often traded over-the-counter
(through broker members of the Forward Freight Agreement Brokers Association - FFABA - such as Clarkson's
Securities, SSY - Simpson, Spence and Young, Braemar Seascope LTD, Ifchor, FIS - Freight Investor Services,
BGC Partners, GFI Group Inc, ACM Shipping Ltd, BRS, Tradition-Platou, ICAPHYDE and IMAREX); but
screen-based trading is becoming more popular, through various screens. Trades can be given up for clearing by the
broker to one of the clearing houses that support such trades. There are four clearing houses for freight: NOS
Clearing, LCH.Clearnet, NYMEX (NY Mercantile Exchange) and Singapore Stock Exchange (Singapore). Freight
derivatives are primarily used by shipowners and operators, oil companies, trading companies and grain houses as
tools for managing freight rate risk. Recently with Commodities now standing at the forefront of international
economics; the large financial trading houses, including banks and hedge funds have entered the market.
Dry Freight or Dry-Bulk FFAs
The Baltic Exchange, Baltic Dry Index which measures the cost for shipping goods like iron ore and grains, doubled
over the past 12 months and has risen more than fourfold since 2006.
The trading volume of dry freight derivatives, a market estimated to be worth about $200 billion in 2007, grew as
those needing ships attempted to contain their risks and investment banks and hedge funds looked to make profits
from speculating on price movements. At the close of the 2007 financial year, the number of traded lots on dry FFAs
doubled the derived physical product.

• Imarex: Freight Derivatives Market FAQ (http://www.exchange.imarex.com/ffa-trading/
• Freight Derivatives explained (http://www.olympicvessels.com/derivatives.php)
• Clarkson's Securities Limited: Freight Forward Agreements (http://www.clarksonsecurities.com/products.
• Simpson, Spence & Young Shipbrokers: Freight Forward Agreements (http://www.ssyonline.com/Services/
• Freight Investor Services: Freight Forward Agreements (FFAs) (http://www.freightinvestorservices.com/ffas)
Inflation derivative 105

Inflation derivative
In finance, inflation derivative (or inflation-indexed derivatives) refers to an over-the-counter and exchange-traded
derivative that is used to transfer inflation risk from one counterparty to another. Typically, real rate swaps also
come under this bracket, such as asset swaps of inflation-indexed bonds (government-issued inflation-indexed bonds,
such as the Treasury Inflation Protected Securities, UK inflation-linked gilt-edged securities (ILGs), French OATeis,
Italian BTPeis, German Bundeis and Japanese JGBis are prominent examples). Inflation swaps are the linear form of
these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative
form for fixed rate bonds), but use a real rate coupon versus floating, but also pay a redemption pickup at maturity
(i.e., the derivative form of inflation indexed bonds).
Inflation swaps are typically priced on a zero-coupon basis (ZC) (like ZCIIS for example), with payment exchanged
at the end of the term. One party pays the compounded fixed rate and the other the actual inflation rate for the term.
Inflation swaps can also be paid on a year-on-year basis (YOY) (like YYIIS for example) where the year-on-year
rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also
monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate
used is still the year-on-year rate.
Options on inflation including interest rate caps, interest rate floors and straddles can also be traded. These are
typically priced against YOY swaps, whilst the swaption is priced on the ZC curve.
Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup at
maturity is exchanged for interest rate payments expressed as a premium or discount to LIBOR for the relevant bond
coupon period, all dates are co-terminus. The redemption pickup is the above par redemption value in the case of
par/par asset swaps, or the redemption above the proceeds notional in the case of the proceeds asset swap. The
proceeds notional equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional
on the LIBOR leg.
Real rate swaps are the nominal interest swap rate less the corresponding inflation swap.

External links
• ISDA Inflation Derivatives Definitions [1]
• Hughston; "Inflation Derivatives" [2]
• Jarrow & Yildirim; "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM
Model" Journal of Financial and Quantitative Analysis, Vol. 38, No. 2, June 2003 [3]
• Huang & Cairns; "Valuation and Hedging of LPI Liabilities" [4]
• Hoare Capital Markets LLP [5]
• "Savvysoft prices inflation derivatives [6]

• Brice Benaben; "Inflation-Linked Products: A Guide for Asset and Liability Managers" Risk Books, 2005. ISBN
• Deacon, Mark, Andrew Derry, and Dariush Mirfendereski; Inflation-Indexed Securities: Bonds, Swaps, and Other
Derivatives (2nd edition, 2004) Wiley Finance. ISBN 0-470-86812-0.
• Brigo, Damiano and Fabio Mercurio; "Interest Rate Models -- Theory and Practice, with Smile, Inflation, and
Credit" (2nd edition, 2006) Springer Finance. ISBN 3-540-22149-2.
Inflation derivative 106

[1] http:/ / www. isda. org/ publications/ isda-inflationdef. html
[2] http:/ / www. mth. kcl. ac. uk/ finmath/ articles/ Inflation_Derivatives. pdf
[3] http:/ / forum. johnson. cornell. edu/ faculty/ jarrow/ 084%20Tips%20JFQA%202003. pdf
[4] http:/ / www. ma. hw. ac. uk/ %7Eandrewc/ papers/ ajgc28. pdf
[5] http:/ / www. hoare-capital. com
[6] http:/ / www. savvysoft. com/ pr_inflation. htm
Article Sources and Contributors 107

Article Sources and Contributors

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Alex 686, Altruism, Amatulic, Analoguni, AndrewHowse, Anomalocaris, Ask123, Aude, Babbage, Beetstra, Berland, Bhuna71, Bigfatloser, BigrTex, Bobblewik, Bonewith, Bryan Derksen,
Btangren, Buddha24, C960657, CSWarren, Caissa's DeathAngel, Calibas, Caltas, Canadaduane, Carax, Chenyu, Chokoboii, ChowSheRuns, Chris Howard, CliffC, Cntras, Cometstyles, Conlinp,
Conversion script, Coolninad, CorvetteZ51, Crasshopper, Cyrius, DMCer, Dami99, Dan131m, DanielVonEhren, Deanlwiley, DerivMan, Derivativeslawyer, Dirnstorfer, DocendoDiscimus,
Donnabuck, Drdariush, Drphilharmonic, EBespoke, Edward, Ehrenkater, Eloz002, Equendil, Erdosfan, Ernie shoemaker, Esb, Evitavired, Eyreland, FBIMON, Falcon8765, Fastfission, Feco,
Fenice, Finnancier, Fishiswa, FreplySpang, GLeachim, Gandalf61, Gansos, Gary King, Gianetta69, Ginette.lacroix, Glennchan, GodfatherOfFX, GraemeL, GreatWhiteNortherner, Gregalton,
GregorB, Gregpalmerx, Grick, Gugustiuci, Hadal, Hairy Dude, HamburgerRadio, Headbomb, Helvetius, Hippodrome, Historymike, Hossain Akhtar Chowdhury, Htournyol, Hu12, Huey45,
Iitkgp.prashant, IstvanWolf, Istvánka, IvanLanin, JMSwtlk, Jarettlee, JayJasper, Jberkes, Jerryseinfeld, Jfeckstein, Jgard5000, JidGom, Jivee Blau, Jmnbatista, Jni, Joe4bikes, Johann Wolfgang,
John Fader, Jprw, Jrleighton, Jvs.cz, Jóna Þórunn, Kchishol1970, Keving 65, Kku, Klp02gtm, KnowledgeEngine, Kummi, Kwertii, Landroni, Lerdsuwa, Levineps, Lfchuang, Lotje, Lotusv82,
M1ss1ontomars2k4, MER-C, Maidonian, Makrem.boumlouka, Manikongo, Marcika, Markmuffet, MartinDK, Mastermund, Mausy5043, Mav, Mdeckerz, Mechanical digger, Medeis, Meg Bill,
MementoVivere, Mic, Michael Hardy, Mishall1281, Misterx2000, Mitsuhirato, Mmaher, Mnmngb, Mo0, Modemrat, MrOllie, Mu5ti, Murphman67, Mydogategodshat, Nameweb, Narssarssuaq,
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Ohnoitsjamie, Olegwiki, Orrorin, Oxymoron83, PCock, Palindrome101, Pcb21, Ph.eyes, Phaldo, Philip Trueman, Philip ea, Phillipb81, Piano non troppo, Piotrus, Plinkit, Ploufman, Portsaid,
Proofreader77, Purplehaziness, QUEWWW, Qaddosh, Quaeler, Question: Are you being served?, RAJESHVK, Rachael0008, Rajah, Rajeshc85, Rajusom, Rangedra, RayBirks, RedWolf,
Renamed user 4, Rich Farmbrough, Rich257, Rinconsoleao, Rjwilmsi, Road Wizard, Roadrunner, Robwingfield, Ronny8, Rosasco, RoyBoy, RxS, Ryan O'Rourke, S0uj1r0, SEOCAG, SJP,
Salsb, Salt Yeung, Sandolsky, Sardanaphalus, Sargdub, Sarma.bhs, Satori Son, Sdrozdowski, Sebrenner, Sekicho, Sgcook, Shadiakiki1986, ShaolinGirl, Shua2000, SimonP, Smallbones,
SmartGuy, SpikeToronto, Spsafw, Starwiz, SteinbDJ, StephenRH, Steven Zhang, Stevenmitchell, StoptheDatabaseState, Strangnet, Stybn, Superm401, Swapspace, Swerfvalk, Swliv, Sybren,
TastyPoutine, Taxman, TerriersFan, Texmex81, TheSix, Themindsurgeon, Tide rolls, Tiger888, To Serve Man, TonyWikrent, Townlake, Tpbradbury, Trade2tradewell, Trasel, Tresiden, Treznor,
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Expofutures, Farmhouse121, Feco, Fenice, Fergusdog, Fintor, Frank Lofaro Jr., GB fan, Gandalf013, Gauge, Gavin.collins, Gene Nygaard, GeneralBob, Georgez (usurped), Gfk, GraemeL,
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Pcxtrader, Pekinensis, Pgreenfinch, Philip Trueman, Piet Delport, Pilotguy, PizzaMargherita, Plinkit, Polly Ticker, Praet123, Psb777, Random user, Rangek, RayBirks, RedWolf, Redthoreau,
Renamed user 4, Rhobite, Rich Farmbrough, Risce, Rmaus, Rmhermen, Ronnotel, Ryguillian, SDC, Sargdub, Satori Son, Sharik, ShaunMacPherson, SimonP, Smallman12q, Solarapex,
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UberScienceNerd, Ughh, Ulner, UncleDouggie, V35322, Veinor, Versageek, VerySmartNiceGuy, Vina, Vsmith, Wavelength, Wcspaulding, When Muffins Attack, Wikomidia, Wongm,
Woohookitty, Wooyi, Wordsmith, Xavid, Yone Fernandes, ZackDude, Zippymobile, Zven, 524 anonymous edits

Forward contract  Source: http://en.wikipedia.org/w/index.php?oldid=410880024  Contributors: AJR 1978, Agmpinia, AlanD, Alanb, Alastairgbrown, Artman772000, BKfi, Barek, Bissinger,
Borgx, CRoetzer, Chokoboii, Comrade Tux, Crocodile Punter, Cyktsui, DabMachine, Dak06, DocendoDiscimus, Donreed, Dying, Edward, Enchanter, Enola, FarmerBob, Favonian, Fenice,
Finnancier, Fintor, Fratrep, Gaius Cornelius, Galen100, Garylhewitt, Gavin.collins, Giler, Happyto, HariniSaladi, Hectorthebat, Hu12, JHunterJ, JMSwtlk, Jerryseinfeld, Jguzmanb, JukoFF,
Julian Mendez, Kalbasa, Kozuch, Mereda, Mitsuhirato, Nbarth, Nisrec, Patrick, Pawanjain19, Permarbor0, Pgwn, Plinkit, Qxz, Radagast83, Random user, Renamed user 4, Rich Farmbrough,
SeptimusOrcinus, Shadiakiki1986, Shadowjams, Smallbones, Snpoj, Spacemoose, Spiritia, Stanleyxu2005, Stevenmitchell, Sunil144, Swerfvalk, TamCaP, TerryE, Thunder8, Ulner, Vicarious,
Warhorus, Woohookitty, Yurik, 114 anonymous edits

Option (finance)  Source: http://en.wikipedia.org/w/index.php?oldid=414211494  Contributors: A3RO, Aaron Brenneman, Acad Ronin, Adamlitt, Afa86, Agbr, Al345, Alcatrank, Aleator,
Alesander, Alfredchew, Anomalocaris, Arconada, Argyrios Saccopoulos, Arichnad, Arthena, Ask123, Aude, Avjoska, Axecution, BanyanTree, Barts1a, BeefWellington, BenFrantzDale,
BigDunc, Bkonrad, Bmicomp, Borisblue, Borracho, Bozoid, Bryan Derksen, Bsadowski1, C960657, Caotuni, Charlie Wiederhold, Christofurio, Cmdrjameson, Cometstyles, Cpm, Cpsdcann,
Crasshopper, Czalex, DMCer, DanTilkin, Danpak, Ddxc, DerHexer, Dfdferer22, DocendoDiscimus, Donreed, Dpwkbw, Drusus 0, Dzhuo, Dzordzm, Eastlaw, Edward, Egopaint, ElBenevolente,
Enochlau, Epbr123, Equitymanager, Erhimanshusavsani, Espoo, Euchiasmus, Exert, FBIMON, Falcon8765, Fawcett5, Feco, Fenice, Finnancier, Fintor, Freedml, Gadfium, Gary King, Garzo,
GeneralBob, Georgez (usurped), Grace E. Dougle, GraemeL, Gtstricky, Guanaco, Gxti, Hadal, Haham hanuka, Hedgestreet, Hraefen, Hu12, Iridescent, Itai, Ivj0915, J.delanoy, JHMM13,
JYolkowski, Jackzhp, JamesBWatson, Jarl Friis, Jasonnoguchi, Jayandsquids, Jerryseinfeld, Jni, JohnClarknew, Jossi, Joyous!, Jphillips, Jsumma, Jurijbavdaz, KBello, KGasso, Kaifer,
Katalaveno, Kbrose, Keenwords, Kelson, Khaderv, Khandelwala1, Kirt Christensen, Klmjet, Kungfuadam, Kuru, Kwertii, Kwi, KyNephi, L Kensington, Lauciusa, Laurinkus, Lawrencekhoo,
Leifern, Levineps, Liftarn, LilHelpa, Lisiate, Lpele, Lphemond, M8250bnb, MER-C, Macbao, Macy, Maurreen, Mayosolo, Medeis, Mellery, Michael Hardy, Mild Bill Hiccup, Mirer, Mkoistinen,
Mu5ti, Mwanner, Mydogategodshat, Nameweb, Nancy.consulting, Nburden, Nehrams2020, No intention of paying for a TV license, Nowa, Octahedron80, Ohnoitsjamie, Optionportfolio,
Optionsgroup, Orimosenzon, OwenX, PHWalls, Pahan, Papercutbiology, Pcb21, Peak6media, PeterM, Pfortuny, Phknrocket1k, Plinkit, Professor859, ProveIt, Quentar, R'n'B, REalSmartInvestor,
Rainpat, Rama's Arrow, Ramnarasimhan, Random user, RayGbetaman, Rbeas, Retail Investor, Rich Farmbrough, Richardminhle, Rinconsoleao, Roadrunner, Ronnotel, Rror, Salt Yeung, Salvar,
Satellite9876, Sbisolo, Sean Whitton, Sethmethod, Sgcook, Shanes, Shawnc, Shimgray, Sidhard, Skimonkey, Smallbones, Smallbones11, Sudfa, Sunkorg, Swerfvalk, Taxman, Tempshill,
Tesseran, Thingg, Thomas Larsen, Thrane, Tide rolls, Tiger888, Toasterpastery, Tony1, Tregoweth, Tritium6, Ulner, Uncle G, Undecidable, UnitedStatesian, V mavros, Vald, Varna burgas,
Vicn12, WallStGolfer31, Wavelength, Wcspaulding, WebScientist, Wendler, Wgmccallum, Wiki5d, Willirennen, Wordsmith, Wormcast, Wragge, Xaine05, Yethey, Yworo, Zain Ebrahim111,
Zerblatt, Zigger, 632 anonymous edits

Call option  Source: http://en.wikipedia.org/w/index.php?oldid=409028096  Contributors: Aeonx, Agbr, Ahoerstemeier, BenFrantzDale, Bluemoose, Boothebeast, Btm, CSWarren, CarbonCopy,
Coppertwig, Cyfal, D6, Darrylbarnes, DiscoverOptions, DocendoDiscimus, Doctor Johnson, Drusus 0, Enchanter, Fastilysock, Fenice, Finnancier, Fintor, Gaius Cornelius, GeneralBob, Gkklein,
Glennchan, GraemeL, Gxti, Hal8999, Hu12, J.delanoy, JHP, JYolkowski, Janviermichelle, Jayjg, Jersey Devil, Jphillips, Kablammo, Kalbasa, Kanie, Kidlittle, Klmjet, Kuru, Lamro, Legis,
Leifern, Loadmaster, Manishji.gupta, Marco Polo, Mentifisto, Mervynl, Mespark, Mfolozi, Mic, Michael Hardy, Mindmatrix, Mitsuhirato, MrDolomite, Nburden, Patrick, Pcb21, Pethr, Quaeler,
Rajah9, Reedy, Rich Farmbrough, Ronark, Ronnotel, Sam Hocevar, Sgcook, Shabbirbhimani, Shyam, SimonP, Slakr, Slawkenbergius, Smallbones, Smallman12q, Sms2010, Static Electric,
SueHay, Taxman, The Thing That Should Not Be, Tpb, Victorgehrke, VladimirReshetnikov, Vsmith, Vzbs34, WallStGolfer31, Zr40, 135 anonymous edits

Put option  Source: http://en.wikipedia.org/w/index.php?oldid=414544228  Contributors: A Train, A. B., Andre Engels, Atlant, Ayla, Bluemoose, Brandon, Bravenewlife, CSWarren, Calion,
CambridgeBayWeather, CarbonCopy, Christopherdunlap, DMCer, Datakid1100, DocendoDiscimus, Doctor Johnson, Drusus 0, ERcheck, Edgar181, Enchanter, Ercolev, Fenice, Finnancier,
Fintor, Gaytan, GeneralBob, Gerard Samuel, GraemeL, Greg Comlish, Gxti, Haigh21, Herr Klugbeisser, Hu12, Humanengr, Investor84, JHP, Jersey Skies, Joconnor, Joshuwaliu, Jphillips,
JurgenG, Juxo, Kablammo, Kalbasa, Ken'ichi, Kevininspace, Kingpin13, Klmjet, Kwertii, Landroni, Legis, Leifern, Loadmaster, Ludwigs2, Mespark, Mfolozi, Mic, Michael Hardy, Mikesheffler,
Mion, Mitsuhirato, Mydogategodshat, NJGW, Nburden, Neelix, Nefertum17, Netsumdisc, Nwbeeson, Obradovic Goran, Optionportfolio, P4VV, Pcb21, Phaldo, Pigman, Potuspflanze,
Prathishpeeriz, Robfletcher, Ronnotel, Sam Hocevar, Savidan, Sgcook, Shabbirbhimani, Smallbones, Surturz, Tebitby, Tkeller28, Vald, Valor, Van helsing, Varmaa, Victorgehrke, Vigormaster,
WallStGolfer31, Wcspaulding, Wooseock, Yasha1969, Zdhan1, Zven, 145 anonymous edits

Strike price  Source: http://en.wikipedia.org/w/index.php?oldid=409566594  Contributors: Apox, Arthena, BenFrantzDale, Bluemoose, DocendoDiscimus, Dysprosia, Finnancier, Fintor,
GeneralBob, GraemeL, Hu12, Isopropyl, Jphillips, LilHelpa, Lukeclimber, MilesFrmOrdnary, Nburden, Pcb21, SchfiftyThree, Sergei Kazantsev, Sisyph, Tebitby, Tesseran, Xcalibus, 22
anonymous edits

Swap (finance)  Source: http://en.wikipedia.org/w/index.php?oldid=414105921  Contributors: 16@r, 970slashx, Aintneo, Arcenciel, Arthur Rubin, Asocall, Beachy,
Benjamin1414141414141414, Benleith, CRoetzer, Cb160, Chansunyanzi, Cmcfarland, Cmdrjameson, Derek Ross, Desx2501, Djmitche, Dkeditor, DocendoDiscimus, Duncharris, Edward,
Fenice, Finnancier, Fintor, Gizbic, GoingBatty, Grkhurana, Hamtechperson, Helvetius, Htournyol, Hu12, Inadarei, Inomyabcs, Interik, JRB-Europe, Jerryseinfeld, JohnCD, Jojalozzo, KGasso,
Kateshortforbob, Kozuch, Krexwall, Lambiam, Lamro, Lars Washington, LeMarsu, Leifern, Levan, Lfchuang, Materialscientist, Miborovsky, Michael Hardy, Mitsuhirato, Mneisen, Mundgan,
Nakulp, Nataly c, Nealcardwell, NickBush24, Oashi, Omarenzi, Patsw, Piano non troppo, Quaeler, Reinoutr, Ronnotel, Sam Hocevar, Scafloc, Shiju.johns, StaticGull, Stevenmitchell, Tesseran,
The Rambling Man, The Thing That Should Not Be, Thepractical, Tohd8BohaithuGh1, Ulner, Vald, Varni1837, Wamiq, Woohookitty, Zhenqinli, 183 anonymous edits
Article Sources and Contributors 108

Interest rate derivative  Source: http://en.wikipedia.org/w/index.php?oldid=413770322  Contributors: 478jjjz, Amit1law, Anwar saadat, Arthena, Arthur Rubin, Bluemoose, Charles Matthews,
CliffC, Danielfranciscook, DocendoDiscimus, Edward, Ex-Nintendo Employee, Feeeshboy, Fenice, Finnancier, Fintor, Joshfinnie, Lancastle, Lfchuang, LilHelpa, Lost-theory, Malin Tokyo,
Meinertsen, Michael Hardy, NYArtsnWords, Pcb21, Pearle, Piloter, Ratesquant, SWAdair, Smallbones, Stuarthill, Sumeetakewar, Woohookitty, Yamamoto Ichiro, 47 anonymous edits

Foreign exchange derivative  Source: http://en.wikipedia.org/w/index.php?oldid=397775368  Contributors: Fintor, Mitsuhirato, 2 anonymous edits

Credit derivative  Source: http://en.wikipedia.org/w/index.php?oldid=408656629  Contributors: Apwhite, Arcenciel, Authoress, Badaribi, Ben.douglas@btinternet.com, Beru7, Blackwong,
Boston2austin, Buildingsaferproducts, Cdosoftware, Chhajjusandeep, Christofurio, Cmdrjameson, Cmprince, Davidmanheim, Davidovic, Diomidis Spinellis, DocendoDiscimus, Drewwiki,
Dvandeventer, Edward, Enerelt, Evitavired, Feco, Fenice, Finnancier, Gaurav2323, Gavin.collins, Gregalton, Greghm, Grendelkhan, Hessamnia, Hippypink, Hu12, Igny, J.delanoy, Jackmass,
JamesAM, JanSuchy, JayJasper, Jerryseinfeld, Jreans, Kelly Martin, Kozuch, Legis, Leon Byford, Meinertsen, Merkurrr, Michael Hardy, Murphy99, Neelix, Neurolysis, Niteowlneils, Nurg,
Nutcracker, Oashi, OwenX, Peter, PigFlu Oink, Piper387, PizzaofDoom, Pnm, Politics0419, Publisher@creditflux.com, Quantifi, Ramin Nakisa, Renamed user 4, RexNL, Rjwilmsi, Roadrunner,
Sangfroid1200, Shamazm2, Shiju.johns, Signalhead, Skierpage, Spiritia, Synchronism, TastyPoutine, The Thing That Should Not Be, USmarcomm, Ulner, Vald, X17bc8, Yonatan, Zain
Ebrahim111, 191 anonymous edits

Equity derivative  Source: http://en.wikipedia.org/w/index.php?oldid=412388234  Contributors: Anwar saadat, Bleechee, Bwpach, Chris the speller, Custardninja, Cww, DMCer, David Gerard,
Decumanus, DocendoDiscimus, Dpr, Enchanter, Equilibrium007, Finnancier, Gandalf61, JLaTondre, Jagged, Ketiltrout, Madbehemoth, Mahanga, Matthew Stannard, Meinertsen,
MementoVivere, Mulder416, Nono64, Ph.eyes, Renamed user 4, Ronnotel, Sargdub, Sortior, Steven Russell, Swerfvalk, Thunderboltz, USmarcomm, 58 anonymous edits

Warrant (finance)  Source: http://en.wikipedia.org/w/index.php?oldid=414557162  Contributors: A i s h2000, AB, AS, Abelson, AnaTo, Arthena, Ayonbd2000, Baronvonmone, Bigdottawa,
Bungofpot, Burgwerworldz, Can't sleep, clown will eat me, Chandrasekhart, Chzz, Civvi, Cjusticehk, CliffC, Cliffb, D6, DavidSol, DocWatson42, DocendoDiscimus, EBespoke, Edward, Ehn,
Enchanter, EoGuy, FBIMON, Feco, Fenice, Finnancier, Fuzzy510, Gcm, Geo8rge, Gnomeliberation front, Ground Zero, Gurch, Hesi7, Hu12, Investingterms, JHunterJ, Japanese Searobin,
Jasonnoguchi, Jdthood, Joflaitheamhain, John of Reading, KaragouniS, Kelson, Koavf, Kooma, Lamro, Leifern, MER-C, Makks2010, MarceloB, Mellery, Merlinme, Mic, Mouäwen, Mulder416,
Nageshk, NigelR, Notinasnaid, Nposs, Nurg, Oashi, Old Guard, PeterSymonds, Plilient, Porges, R9tgokunks, RJFJR, Ronnotel, Ronz, Sargdub, SecondMarket, Inc., Sgcook, Sigmundur,
Snoeks78, Spike Wilbury, Sybren, Tathaeco, Taxman, The Letter J, Tjamesjones, Toon05, Truc Tran, Wcspaulding, White Trillium, Woohookitty, 109 anonymous edits

Foreign exchange option  Source: http://en.wikipedia.org/w/index.php?oldid=413786433  Contributors: Anwar saadat, Auntof6, Chochopk, Dharesign, DocendoDiscimus, Dominic, Edward,
Finnancier, Fintor, Gadfium, GeneralBob, GraemeL, Hu12, Icecold1, Igorn, Jeff G., Jfr26, Marrante, Nbarth, Nikossskantzos, Niwat19, Ohnoitsjamie, Paxse, Pcb21, Pit3001, Poccil, Ramillav,
SDC, Severo, Sgcook, Smallbones, Stephennt, Takeiteasyfellow, Tapir Terrific, Vald, Սահակ, 66 anonymous edits

Gold as an investment  Source: http://en.wikipedia.org/w/index.php?oldid=415074893  Contributors: 84user, 911txt, AFewGoodMen, Aapo Laitinen, Aaronchall, Aeporue, Aktsu, Alai,
Alchaemist, Aldis90, AlexE, AllGloryToTheHypnotoad, Although, AmosWolfe, AndrewHowse, Anwar saadat, Appleseed, Arichnad, Arthena, Athkalani, BD2412, Badgerta, Barabum, Ben Ben,
Bender235, BertilBeiber, Bkell, Bobblewik, Bobo192, Boromir123, Bschott, Buck Mulligan, Bullion3, Burgwerworldz, Caleefe, Calwatch, Carbonate, Cbustapeck, Cenarium, Charlie
Wiederhold, Chris Capoccia, Chris. Fulker, Chronodm, Closedmouth, Cmdrjameson, CommonsDelinker, Coneslayer, Creelbm, Crosbiesmith, DARTH SIDIOUS 2, DHollerman, David s graff,
De728631, DeadEyeArrow, Deli nk, Delirium, Deon Steyn, DickClarkMises, DocendoDiscimus, Dominic Sayers, Donarreiskoffer, Download, Drake Wilson, Dredlox, Dspradau, Dublinclontarf,
Dynamicsoul, Ecki, Edward, Ehrenkater, Elcobbola, Elizabethwindsor, Eloil, Emilfaro, Eurosong, FF2010, Facts707, Favonian, Firsfron, Fish and karate, Fjarlq, Florentino floro, Flowanda,
Fluxist, Fubar Obfusco, Furtive admirer, Gary King, Gene Nygaard, George Esayas, Giftlite, Gokusandwich, GoldCore, Gryffon, Gseletko, Gwernol, Gyre, Happy-melon, Haza-w, Herberq,
Hipocrite, Hmrox, Hu12, ICouldBeWrong, Iain99, IncidentalPoint, Ingolfson, InsideGold, Itai, J. Finkelstein, JPMorgan2, Jamesking2007, Jazzy2fives, Jbg.gold, Jburt1, Jdcanfield, Jebiggs,
Jesseoneill, Jni, Jnmhorn, Jnojr, JoCoNo, JoanneB, Jogloran, John Bahrain, John Maynard Friedman, John of Reading, Joseph Solis in Australia, JosephLondon, Jrtayloriv, Julesd, Jwojdylo,
Ka1f42060, Kaiser matias, Kaktookee, Katydidit, Kbrose, Kedarnath7, Kimbly, Kitteneatkitten, KnowledgeOfSelf, KoshVorlon, Kubanczyk, Kuru, Lalala666, LanguageMan, Leszek Jańczuk,
Leuko, Lightmouse, Likeem, Marcika, Markspspite, Markustwofour, Maslakovic, Mattlencfc, MaxHeadroom, Meco, Mellery, Mervyn, Miss Madeline, Monkeyman, Mooglemoogle, Mr.Z-man,
MrVoluntarist, Mrmadcat, Mutamarrid, NTK, Natgoo, Nbhatla, Netdance, NewEnglandYankee, Nickshanks, NintendoWiki, Nirvana2013, Noddy the patriot, Nopetro, Notedgrant, Nv8200p,
Ohnoitsjamie, Opello, Pauly04, PetePierre, Peterlewis, Philip Trueman, Philip ea, Plazak, Prestonp, Psb777, Publicus, Pyg, Quuxplusone, RainbowOfLight, RandomP, RayBirks, Realissimo,
Reuvenk, RexNL, Rhebus, Rhyeal, Riana, Ricky@36, Rjwilmsi, Rlouie69, Rm999, Roadrunner, Robert Ullmann, Rod57, Ronhjones, Rror, RucasHost, SSZ, Saharadesertfox, Saperaud, Sargdub,
Scott Burley, Sebastianpinay, Sesu Prime, Shhhh, Siddhant, Silverbach, Simpsons contributor, Sir George Athelstone II, Slow Riot, Smashville, Smoo2u, Snori, Spaceport, Spangineer, Stephen B
Streater, Stevedekorte, StevieNic, Stheller, Stybn, Suffusion of Yellow, Sukiari, Surv1v4l1st, Swiss Banker, THF, Taffenzee, Tamanrasset444, TastyPoutine, Tbird2011, Tdjewell, Tennii, Teryx,
Texture, Thatedeguy, The Anome, The undertow, TheRasIsBack, Thewriter23, Thinkvoyager, Tkeller28, Tokyoahead, Tpbradbury, Trickyt, Triwbe, Twigletmac, Urlass, UweWichmann,
Valentinian, Vgranucci, Victorgrigas, Vipinhari, Vsmith, WMFEssaywriter, Watercolour, Wikimodulators, Wikiwikiwiki user wiki, Willch, Wtmitchell, Xanthis, Xyzzyplugh, Yworo, Zazou,
Zzuuzz, 639 anonymous edits

Credit default swap  Source: http://en.wikipedia.org/w/index.php?oldid=414981315  Contributors: 21655, 7spinner, 84user, Aadal, Abe.Froman, Abune, Ajb2029, AliMaghrebi, Allstar86,
Amikake3, Amniarix, Amys995, AnOddName, AndyWong343, Andyseaman, Andyyso, Anual, Appraiser, ArnoldReinhold, Astor Piazzolla, Atmoz, Auric, Authoress, Banquer, Barek, Barkeep,
Bchabala2, Beland, BenFrantzDale, Benbest, Bfrenkel, Bidaskspread, Blahfasel, Boffothebear, Bolo1729, BrianDaubach10, Brianboonstra, Brighterorange, CRoetzer, CSTAR, Calpass,
Camerojo, Campoftheamericas, Capricorn42, Cartan, Catsqueezer, Cds casey, Charles Matthews, Chhajjusandeep, Cmdrbond, Cmlong, Coolcaesar, Corbyboo, Cronos12, Ctk56, Cyktsui,
DMCer, DO56, Darth Panda, Dataleft, Decora, Deepmath, Deineka, DerivMan, DerryTaylor, Diomidis Spinellis, DocendoDiscimus, Donfbreed, Download, Dratman, Dsg101, Dthomsen8,
Duedilly, Dyoung418, Dysmorodrepanis, Eastlaw, Ed.Markovich, EdWiller, Edward Vielmetti, Eehellfire, Elconde, Elektron, Erdosfan, Eurobas, Evitavired, Extremepro, FCYTravis, Feckler
account, FeydHuxtable, Filnik, Financestudent, Finnancier, Fishiswa, FitzColinGerald, Flewis, Flowanda, Fsiler, Geitost, Geregen2, GoodDamon, GordonGross, Gorgalore, Greghm, GregorB,
Ground Zero, Gruntler, Guy M, HHHEB3, Hedychium, Helvetius, HenryLi, Hmains, Hu12, Iamorlando, Igor47, JForget, JanSuchy, Jasper50, Jaysweet, Jberkes, Jblasdel, Jeffq, Jerryseinfeld,
Jewzip, Jim whitson, Jni, JohnnyB256, Johnsonb52, Jonnay, Juxo, Jvs.cz, Jwbaumann, Kbdank71, Keisetsu, Khaderv, Klaas1978, Klip game, Koavf, Kuru, L33th4x0rguy, Lamro, Lan Di,
LanceCross, Ld100, LegalTech, Leifern, Leon Byford, Lightmouse, LilHelpa, Ling.Nut, Madhero88, Magioladitis, Manop, Marieduville, MartinRinehart, Mauls, Mayank.singhi, Mboumlouka,
Mbutuhund, Mdeckerz, MerlinMM, Mervyn, Mervyn Emrys, Mic, Michael Hardy, Mikenlesley, Mkosara, Mlehene, Mobb One, Monterey Bay, Mtraudt, Murphy99, Nandt1, Nbarth, Neilc,
Nshuks7, Nudecline, Nunquam Dormio, Ohconfucius, Ohnoitsjamie, OldZeb, OwenX, Palea, Paul Jorion CFC, Pcuk, Peterbr, Peterjleahy, Picofluidicist, Piloter, Pizzadeliveryboy, Pontificalibus,
QTCaptain, Quasirandom, QueenCake, Quotemstr, RP459, Ramin Nakisa, Rdouglas2007, Reiska, Relaxing, Rettetast, Rheras, Rhobite, Rich Farmbrough, Ripe, Rjwilmsi, Rkjackso,
Rmburkhead, Robma, Rror, Rutland Square, Rwmcm, SDC, Sanjaykankaria, Sebculture, Sethop, Shawnc, Shmiluwill, Shshao, Simon123, Sixtyninefourtyninefourtyfoureleven, Smaines,
SmartGuy, Smooth0707, Smusser, Solarapex, Sperxios, Stewartj76, Taral, Tassedethe, TastyPoutine, TaxHappy, Taxman, Terets, Timneu22, Tinlash, Tpb, Tpbradbury, Tripodian, Tristanreid,
Tritium6, Trondtr, U, Ulric1313, Unstable-equilibrium, Unvarnishedtruth, Uucp, Vald, Vhadiant, Vinjcir, Vlad, Wavelength, WebSurfinMurf, WikiTome, Woohookitty, Workingsmart, Wragge,
Wyattmj, X17bc8, YUL89YYZ, Yellowdesk, Ytchuan, Zain Ebrahim111, 608 anonymous edits

Equity swap  Source: http://en.wikipedia.org/w/index.php?oldid=397775295  Contributors: Abhideb1981, Abhishekgulati, Airmark, Ameliorate!, Arthena, Bahnemann, Bhadani, Brown motion,
CWA, DMCer, DocendoDiscimus, Edward, Fenice, Finn-Zoltan, Finnancier, Gnfnrf, Helene descomps, Jengod, Kahasabha, Leifern, Lfchuang, LilHelpa, Peripitus, Sir Bertie Wooster,
Smooth0707, Taxman, Unbehagen, Unstable-equilibrium, Woohookitty, 39 anonymous edits

Property derivatives  Source: http://en.wikipedia.org/w/index.php?oldid=407865469  Contributors: Aiuw, Annamariagfi, BrettScott, Derivinfo, Dumas41, Evitavired, Falcon8765, Gwguffey,
John of Reading, Klp02gtm, Propertyexpert, RichardVeryard, Rjwilmsi, Robina Fox, Sheathy, Wmathers, 34 anonymous edits

Freight derivative  Source: http://en.wikipedia.org/w/index.php?oldid=397775416  Contributors: 7, Arsenikk, Arthurw2802, Baltic-fanatic, Bednarb, Blanca.menchaca, Braemarseascopeltd,
Charles Matthews, Docu, Elysium333, Fenice, Gaius Cornelius, Godagama, Jfurr1981, Lancaster32, Loserplatz, Mamouganer, Mereda, MichaelJanich, MrOllie, Nakon, Pcb21, Pny, Reconsider
the static, RedWolf, Sargdub, Tabletop, Trade2tradewell, 37 anonymous edits

Inflation derivative  Source: http://en.wikipedia.org/w/index.php?oldid=406713481  Contributors: BD2412, Biebdj, Christophenstein, Daf, DmitTrix, Drdariush, Enochlau, Finnancier,
Funandtrvl, Greensburger, Guy M, Liné1, MuffledThud, Quantyz, TastyPoutine, 23 anonymous edits
Image Sources, Licenses and Contributors 109

Image Sources, Licenses and Contributors

Image:Chicago bot.jpg  Source: http://en.wikipedia.org/w/index.php?title=File:Chicago_bot.jpg  License: unknown  Contributors: Infrogmation, JeremyA, Leslie, Yonatanh, 1 anonymous edits
Image:Total world wealth vs total world derivatives 1998-2007.gif  Source: http://en.wikipedia.org/w/index.php?title=File:Total_world_wealth_vs_total_world_derivatives_1998-2007.gif
 License: Public Domain  Contributors: User:Analoguni
File:Futures Trading Composition.jpg  Source: http://en.wikipedia.org/w/index.php?title=File:Futures_Trading_Composition.jpg  License: Creative Commons Attribution 3.0  Contributors:
File:Long_forward_payoff.png  Source: http://en.wikipedia.org/w/index.php?title=File:Long_forward_payoff.png  License: Creative Commons Attribution-Sharealike 3.0  Contributors:
File:Short_forward_payoff.png  Source: http://en.wikipedia.org/w/index.php?title=File:Short_forward_payoff.png  License: Creative Commons Attribution-Sharealike 3.0  Contributors:
File:Contangobackwardation.png  Source: http://en.wikipedia.org/w/index.php?title=File:Contangobackwardation.png  License: Creative Commons Attribution-Sharealike 3.0  Contributors:
Image:Long call option.svg  Source: http://en.wikipedia.org/w/index.php?title=File:Long_call_option.svg  License: Creative Commons Attribution 3.0  Contributors: User:Gxti
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