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Derivatives are the fastest-growing, most dynamic segment of the modern financial markets. They complement spot market instruments and create new opportunities for the transfer of risk among market participants. Derivatives trading is contributing increasingly to price discovery on financial markets.
On the other hand, derivative instruments can also give rise to additional risks, such as counterparty risk and risks to financial market stability. The present report focuses on the latter, with regard to the potential feedback effects of derivatives markets on the underlying spot markets. One example of such feedback is if derivatives are replicated or hedged by buying and selling the underlying asset on the spot market. This can amplify price fluctuations through pro-cyclical purchases and sales of the underlying asset on the spot market.
Robust market structures are a primary method of avoiding destabilising effects. Moreover, regulatory measures such as price ranges or trading halts can help to defuse crisis situations.
Spectrum of derivatives
Derivatives include financial products such as options, forward rate agreements, futures, certificates and swaps. The market value of such derivative instruments can be derived from the movement of the value of the underlying asset (eg bonds, stocks, commodities) on which they are based.
Derivatives are traded either in a standardised form (eg exchange-traded futures) or directly between the contractual parties, ie "over the counter" (OTC). The most important exchanges for organised derivatives trading worldwide are the German-Swiss futures and options exchange EUREX, the UK's International Financial Futures Exchange (LIFFE), and the US financial and commodities exchanges Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME).
Potential incentives for derivatives trading include deriving disproportionate benefit from the price movement of the underlying asset for just a relatively small capital input or profiting from falling prices. On the other hand, derivatives are also used to hedge against fluctuations in the price of the underlying asset.
How the market for derivatives has evolved
Trade in derivatives has increased sharply in the past two decades. It was initially focused on equities and commodities markets; the strategies tested in those markets were subsequently also applied to interest rate risk and exchange rates. Credit derivatives, with which credit risk can be decoupled from the underlying credit transaction and traded separately or created from scratch,...