An Overview of the Derivatives Marketplace

Abstract

Financial derivatives – or contracts that derive their value from financial market references – were created by global intermediaries and exchanges starting in the 1970s as a mechanism for capitalizing on, or protecting against, movements in increasingly volatile markets. Although basic derivatives on commodities had already existed for many decades, the market volatility present from the early 1970s onward led to increased innovation and participation in the financial segment of the marketplace.¹ After several decades as part of the “mainstream,” financial derivatives have proven they can be useful in helping institutions achieve certain goals; at the same time, losses and other problems reflect the fact that they can also be quite destructive.

We’ve spoken with the client and we’re ready to sell him a two-year, 10 percent out-of-the-money Asian/average price two-power put on the Hang Seng Index with a quanto into yen; the client will pay us 12 month yen Libor plus 50 as premium.

(Derivatives salesman in conversation with his sales manager)

I do not for one moment wish to suggest that you have got it all wrong. What I do ask is, are you quite sure you have got it all right?

(R. Farrant, Deputy Head of Banking Supervision, Bank of England, March 1992, in an address to participants at International Swaps and Derivatives Association (ISDA) conference)

These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to development of a far more flexible, efficient, and resilient financial system than existed just a quarter century ago.

(A. Greenspan, Chairman, Federal Reserve Board, November 2002 speech)

[D]erivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

(W. Buffett, Chairman and CEO, Berkshire Hathaway, March 2003, in the Berkshire Hathaway annual report)