Chapter Eighteen

Derivative Financial Instruments

Derivatives are financial products, such as futures contracts, options, and mortgage-backed securities. Most of the value of derivatives is comprised on the value of an underlying security, commodity, or other financial instrument that has a value, based on the expected future price movements of the asset to which it is linked called the underlying asset. Derivative financial instruments have grown rapidly because of the dynamics of the global financial markets, the ever-lasting fluctuation in interest and currency exchange rates, the complexity of financial engineering, and their potential profitability. Commercial banks in the United States reported outstanding derivatives contracts with a national value of $33 trillion in 1999 comparing to $ 231.2 trillion in 2010. The trend in derivatives transactions shows a steady growth of about 20 percent compound annual rate increase since 1990. Of the $33 trillion reported outstanding derivatives national value, only $4 trillion were exchange-traded derivatives. The remainder were off-exchange or over-the-counter (OTC) derivatives.1 Derivatives are defined as any financial instruments or other contracts (e.g, futures, forwards, options, swaptions, caps, collars, and floors) with one or more underlyings (e.g., interest rate, index security price, commodity price, foreign exchange rate, or some other variables) with one or more notional amounts or payment provisions or both (e.g., face ...

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