- Financial Derivatives: Definition, Types, Risks - The Balance
- What Is a Derivative and How Do Derivatives Work?
- Financial Derivatives - University of California, Los Angeles

Before that let me clarify a point. There is a common misconception that derivatives would bring financial ruin. That’s not true. Derivatives by them selves do not bring in any additional risk to the economy. Improper handling of derivatives can cause damage – now, isn’t that true with anything we handle in life? So the root cause of any loss through derivatives is not the problem of derivatives.

Of course, the financial ruin of America started with the complex transactions on derivatives.. President Barack Obama recently said that he will veto legislation that does not bring the derivatives market under control so that he can assure that America does not have the same kind of crisis that they have seen in the past.

## Financial Derivatives: Definition, Types, Risks - The Balance

9. Short-term interest rates: Libor

Libor, which stands for London Interbank Offered Rate, is the interest rate paid on interbank deposits in the international money markets (also called the Eurocurrency markets ). Libor is commonly used as a benchmark for short-term interest rates in setting loan and deposit rates and as the floating rate on an interest rate swap. The most commonly used Libor rate is BBA Libor , which is sponsored by the British Bankers Association it is defined as &ldquo an indication of the average rate a leading bank, for a given currency, can obtain unsecured funding for a given period in a given currency.&rdquo

### What Is a Derivative and How Do Derivatives Work?

Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterparty than do standardized derivatives.

#### Financial Derivatives - University of California, Los Angeles

Leverage can be greatly enhanced by using derivatives. Derivatives, specifically options are most valuable in volatile markets. When the price of the underlying asset moves significantly in a favorable direction, then the movement of the option is magnified. Many investors watch the VIX (Chicago Board Options Exchange Volatility Index) which measures the volatility of the S& P 555 Index options. High volatility increases the value of both puts and calls.

75. Credit exposures associated with options

For a buyer of an option, the amount at risk is generally the value (premium) of the option at default. For the seller of an option, there is no credit exposure.

Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With differing values of different national currencies , international traders needed a system of accounting for these differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data , such as the amount of rain or the number of sunny days in a particular region.

6. What is a derivative?

A derivative is a risk transfer agreement, the value of which is derived from the value of an underlying asset. The underlying asset could be an interest rate, a physical commodity, a company&rsquo s equity shares, an equiity index, a currency, or virtually any other tradable instrument upon which parties can agree.

The Bottom Line

The proliferation of strategies and available investments has complicated investing. Investors who are looking to protect or take on risk in a portfolio can employ a strategy of being long or short underlying assets while using derivatives to hedge, speculate or increase leverage. There is a burgeoning basket of derivatives to choose from, but the key to making a sound investment is to fully understand the risks - counterparty, underlying asset, price and expiration - associated with the derivative. The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a portfolio strategy.

The above process is technically called 8766 Hedging 8767 . ie,making an investment to offset the potential loss of another investment.

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