What are derivatives?
Derivatives are financial instruments whose values are contractually linked to the prices of other financial market variables such as interest rates, FX rates, credit, equity indices and other asset classes.
Developed to provide an efficient means of transfer for different types of risk, now more than 90% of the worlds largest corporations and all major financial institutions actively use derivatives to manage their financial risk exposures. Derivatives can also be used for trading and investment purposes, offering alternative ways for traders, money managers and other types of investor to gain exposure to market risk.
There is enormous diversity within derivative markets, that ranges from exchange traded listed derivatives to the (larger) over-the-counter (OTC) markets, and across a broad spectrum of products, from simple futures and forward contracts to options and highly complex exotic derivatives.
What are the need to know terms?
CVA Credit Valuation Adjustment (also DVA Debit Valuation Adjustment)
CVA represents the estimated market value of counterparty credit risk exposure, arising from uncollateralised OTC derivative transactions. Now required under accounting and regulatory standards, CVA and DVA measurement represent an additional burden for the OTC derivatives industry, and additionally creates a new source of market risk, leading to the establishment of CVA hedging desks to measure and manage such exposures.
OTC Over the Counter
Derivative instruments can exist as as over the counter (OTC) derivatives, privately negotiated contracts traded bilaterally but increasingly via organised electronic trading platforms (swap exchange facilities (SEFs) or Organised Trading Facilities (OTFs)). The OTC derivatives market dwarfs the listed derivatives markets, with a total volume (notional principal) approaching USD 600 trillion,
The International Swaps and Derivatives Association fulfils a number of critical roles in relation to the global OTC derivatives industry, most notably in the drafting and generation of a legal documentation to facilitate trading of over the counter derivatives. This centres on the ISDA Master Agreement, a bilateral master agreement governing the contractual basis of all OTC derivative transactions.
Also referred to as dual curve pricing or CSA discounting, the subject of OIS discounting refers to recent modifications in OTC derivatives valuation models to better reflect changes in market pricing and to recognise the greater use of collateralisation in bilateral transactions and centrally cleared transactions.
Structured products represent a synthesis of derivative instruments and more conventional securities, and provide a means for investors of all types to gain access to a wider range of markets, risk and return characteristics than offered by more conventional investment vehicles.