A derivatives market is any market for a derivative security, that is a contract which specifies the right or obligation to receive or deliver future cash flows based on some future event such as the price of an independent security or the performance of an index.
Derivatives markets can be standardized (many users trading fungible contracts, typically on an exchange) or non-standardized (where derivitives are customized for the user by a trading desk - the over-the-counter market). One derivatives market is for standardized stock options, a market where parties can buy or sell, call or put options on a secondary market. Non-standardized derivatives instruments,such as naked warrants issued directly by financial institutions to a secondary market, also exist.
Other derivative markets include those for interest rate swaps, credit default swaps and options and forwards on foreign exchange.
Derivatives are one of the most rapidly growing and changing areas of modern finance. According to the Bank for International Settlements, at the end of June 2004, the "total estimated notional amount of outstanding OTC contracts" at reporting institutions stood at $220 trillion while "exchange-traded contracts" stood at $53 trillion ( (http://www.bis.org/publ/regpubl.htm)).
Derivatives facilitate risk management by allowing a person to reduce his exposure to certain kinds of risk by transferring those risks to another person that is more willing and able to bear such risks.
Derivatives were used to hide debt that should be reported in regular corporate reports, fabricate income on the same corporate reports and dodge taxes to the government.
A series of derivatives between the same counterparties can be abused to create a loan from one firm to another that is not reported as debt but rather as income in one period when the "loan" is made and then a loss in a later period when the "loan" is repaid.
Derivatives are important to the financial markets and the world economy because they provide a means for companies to separate and trade various kinds of risks.
Derivatives dealers are exposed to at least the same risks as hedgers, and they incur additional operational risks as a result of the sheer volume of derivatives activity they undertake.
Derivatives concentration risk is similar in concept to an industry concentration in that the counterparties to a dealer have an economic interrelationship through their involvement in a derivativesmarket that is dominated by a few dealers.
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