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The following definitions are provided for educational purposes only. They are not in any way meant to serve as legal or official definitions, nor are they meant to serve as standard market definitions. In practice, terminology can differ across firms and across market segments.

  1. What is a derivative?
  2. Major derivative categories
  3. How do privately negotiated (OTC) derivatives differ from futures?
  4. How do cleared derivatives differ from OTC derivatives?
  5. Product description: Forward contracts
  6. Critical dates in derivatives transactions
  7. Definition: Notional principal
  8. Product description: Forward rate agreements (FRA)
  9. Short-term interest rates: Libor
  10. What is a swap?
  11. Product description: Interest rate swaps
  12. Critical dates for interest rate swaps
  13. Risks associated with interest rate swaps
  14. Suppose a client enters into an interest rate swap with a derivatives dealer to protect against rates rising by locking in a fixed rate. Doesn’t that mean the dealer expects rates to fall? Otherwise, why would the dealer take on the risk of losing money?
  15. The value of an interest rate swap
  16. Credit risks associated with swaps
  17. What is the actual amount at risk in a swap?
  18. Product description: Options
  19. How do options differ from swaps and forwards?
  20. Credit exposures associated with options
  21. Is an option a form of insurance?
  22. Product description: Interest rate options
  23. Currency derivatives
  24. Product description: Cross-currency swaps
  25. What is a credit derivative?
  26. Product description: Credit default swaps
  27. What risks does do the parties to a credit default swap give up and what risks do they take on?
  28. Product description: Total return swaps
  29. What risks does do the parties to a total return swap give up and what risks do they take on?
  30. Why is derivatives documentation (such as the ISDA Master Agreement) important?
  31. Definition: Payment netting
  32. Definition: Close-out netting
  33. What is the status of an individual transaction under the ISDA Master Agreement?
  34. What are commodity derivatives?
  35. How do commodity markets differ from financial markets?
Product Descriptions and some Frequently Asked Questions

1. 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’s equity shares, an equiity index, a currency, or virtually any other tradable instrument upon which parties can agree.


2. Major derivative categories
Derivatives fall into three categories. The first is over-the-counter (OTC) derivatives, which are customized, bilateral agreements that transfer risk from one party to the other. OTC derivatives, which are sometimes called swap agreements or swaps, are negotiated privately between the two parties and then booked directly with each other. The second category consists of standardized, exchange-traded derivatives, which known generically as listed derivatives or futures. In contrast with OTC derivatives, listed derivatives are executed over a centralized trading venue known as an exchange and then booked with a central counterparty known as a clearing house. Finally, the third category is cleared derivatives, which like OTC derivatives are negotiated bilaterally, but like listed derivatives are booked with a clearing house.

3. How do privately negotiated (OTC) derivatives differ from futures?
First, the terms of a futures contract—including delivery places and dates, volume, technical specifications, and trading and credit procedures—are standardized for each type of contract. For swaps, the same characteristics are subject to negotiation by the parties to the contracts. Second, futures contracts are always traded on an exchange, while swaps are traded on a bilateral basis. Third, those who engage in futures transactions assume exposure to default by the exchange’s clearinghouse; for OTC derivatives, the exposure is to default by the counterparty. Fourth, credit risk mitigation measures, such as regular mark-to-market and margining, are automatically required for futures but optional for swaps. Finally, futures are generally subject to a single regulatory regime in one jurisdiction, while swaps—although usually transacted by regulated firms—are transacted across jurisdictional boundaries and are primarily governed by the contractual relations between the parties. Various products, including futures contracts and exchange-traded options, fall within the generic category of futures, but all have the common characteristics described above.


4. How do cleared derivatives differ from OTC derivatives?
As mentioned above, OTC derivatives are booked bilaterally between the counterparties while cleared derivatives are booked with a clearing house. OTC derivatives counterparties therefore assume credit exposure, known as counterparty credit risk, to each other while cleared derivatives counterparties are exposed to credit risk of the clearing house. Second, cleared derivatives always involve the posting of margin to the clearing house by the parties to a trade, while margining by OTC derivatives counterparties is subject to negotiation by the parties. Finally, the terms of OTC derivatives can be customized to fit the needs of the contracting parties. The terms of cleared derivatives, in contrast, involve a high degree of standardization The reason for standardization of cleared derivatives is to facilitate the computation of required margin amounts. The following table summarized the distinctions between OTC, cleared, and listed derivatives

OTC
Cleared
Exchange-traded
  • Trades negotiated over-the-counter
  • Customized contracts are broken down by trading desk into tradable risks and hedged in liquid markets
  • Traded between dealers as principals
  • Dealer is normally counterparty to all trades
  • Margin (collateral) often exchanged but subject to negotiation between counterparties
  • Trades negotiated over-the-counter
  • Trades limited to standardized contracts
  • All trades are booked with clearinghouse, which is counterparty to all trades
  • Mandatory margin requirements
  • Initial margin
  • Variation margin
  • Daily settlement (mark to market) and margin calls
  • Trades executed on organized exchanges
  • Trades limited to standardized contracts
  • All trades are booked with exchange’s clearinghouse, which is counterparty to all trades
  • Mandatory margin requirements
  • Initial margin
  • Variation margin
  • Daily settlement (mark to market) and margin calls

5. Product description: Forward contracts
A forward is a customized, bilateral agreement to exchange an asset or cash flows at a specified future settlement date at a forward price agreed on the trade date. One party to the forward is the buyer (long), who agrees to pay the forward price on the settlement date; the other is the seller (short), who agrees to receive the forward price. Entering a forward contract typically does not require the payment of a fee.

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6. Critical dates in derivative transactions
The trade date is the date on which the parties agree the terms of a contract. The effective date is the date on which the parties begin calculating accrued obligations, such as fixed and floating interest payment obligations on an interest rate swap. The termination date (often called maturity date) is the date on which obligations no longer accrue and the final payment occurs. The term of a transaction lasts from the effective date to the termination date.

7. Definition: Notional principal
Notional principal, or notional amount, of a derivative contract is a hypothetical underlying quantity upon which interest rate or other payment obligations are computed.

8. Product description: Forward rate agreements (FRA)
A forward rate agreement is a forward contract on a short-term interest rate, usually Libor, in which cash flow obligations at maturity are calculated on a notional amount and based on the difference between a predetermined forward rate and the market rate prevailing on that date. The settlement date of an FRA is the date on which cash flow obligations are determined.

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 “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.”

10. What is a swap?
A swap is a bilateral agreement to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the transaction (maturity or tenor). Entering a swap typically does not require the payment of a fee.

11. Product description: Interest rate swaps
An interest rate swap is an agreement to exchange interest rate cash flows, calculated on a notional principal amount, at specified intervals (payment dates) during the life of the agreement. Each party’s payment obligation is computed using a different interest rate. In an interest rate swap, the notional principal is never exchanged. Although there are no standardized swaps, a plain vanilla swap typically refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating rate (usually Libor).

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12. Critical dates for interest rate swaps
In addition to the trade date, effective date, and termination date mentioned above, the reset date is the date on which a new floating rate becomes effective. The new floating rate is typically determined two days before the reset date (sometimes called fixing date). Floating rate payment amounts are calculated for a specified calculation period. The first calculation period is the period between the effective date and the first period end date; thereafter the calculation periods are the time between period end dates.  

13. Risks associated with interest rate swaps
A party entering a swap takes on exposure to a given interest rate; the exposure can be long or short depending on whether a counterparty is paying or receiving the fixed rate. At the same time, each party take on the risk - known as counterparty credit risk - that the other party will default at some time during the life of the contract.

14. Suppose a client enters into an interest rate swap with a derivatives dealer to protect against rates rising by locking in a fixed rate. Doesn’t that mean the dealer expects rates to fall? Otherwise, why would the dealer take on the risk of losing money?
The dealer’s view on interest rates does not matter. When the dealer assumes a client’s risk, the dealer typically lays off—that is, hedges—that risk with an offsetting transaction. Suppose, for example, a dealer enters into a swap in which the client pays a fixed rate to the dealer and the dealer pays a floating rate to the client. The dealer could hedge the risk by entering into an offsetting swap with another client or dealer. Or, it could take a Treasury security position with interest rate exposure that offsets the swap. Or, it could take an offsetting futures position. Over the entire portfolio some risks might be uncovered at various times—which is essential to the existence of a liquid market—but such risks are carefully monitored and controlled by dealers.

15. The value of an interest rate swap
The value of an interest rate swap to a counterparty is the net difference between the present value of the payments the counterparty expects to receive and the present value of the payments the counterparty expect to make. At the inception of the swap, the value is generally zero to both parties, and becomes positive to one and negative to the other depending on the movement of interest rates. Present value is the value of a quantity to be received in the future, adjusted for the time value of money (interest foregone while waiting for the quantity).

16. Credit risks associated with swaps
Loss on a swap occurs if two things happen: First, the counterparty must default; and second, the swap must have a positive value to the party that does not default. The amount of the loss depends on the credit exposure of the swap.

17. What is the actual amount at risk in a swap?
The credit exposure of a swap is the amount that would be lost if default were to occur immediately. Credit exposure is generally equal to the current market value if positive, and zero if current market value is negative. Swap participants also calculate future exposures of swaps, which are potential positive values during the life of the swap; future exposures are used to establish credit charges (expected exposure) and credit limit usage (peak exposure).

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18. Product description: Options
An option is an agreement that gives the buyer, who pays a fee (premium), the right—but not the obligation—to buy or sell a specified amount of an underlying asset at an agreed upon price (strike or exercise price) on or until the expiration of the contract (expiry). A call option is an option to buy, and a put option is an option to sell.

19. How do options differ from swaps and forwards?
In a forward or swap, the parties lock in a price (e.g., a forward price or a fixed swap rate) and are subject to symmetric and offsetting payment obligations. In an option, the buyer purchases protection from changes in a price or rate in one direction while retaining the ability to benefit from movement of the price or rate in the other direction. In other words, the option involves asymmetric cash flow obligations.

20. 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.

21. Is an option a form of insurance?
Options differ from insurance in that options do not require one party to suffer an actual loss for payment to occur. In addition, the owner of an option need not have an insurable interest - such as ownership in the underlying asset - in the option.

22. Product description: Interest rate options
In an interest rate option, the underlying asset is related to the change in an interest rate. In an interest rate cap, for example, the seller agrees to compensate the buyer for the amount by which an underlying short-term rate exceeds a specified rate on a series of dates during the life of the contract. In an interest rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during the contract period. A collar is a combination of a long (short) cap and short (long) floor, struck at different rates. Finally, a swap option (swaption) gives the holder the right - but not the obligation - to enter an interest rate swap at an agreed upon fixed rate until or at some future date.

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23. Currency derivatives
A currency forward is a contract in which the parties agree to exchange cash flows in two different currencies at an agreed upon date in the future. A cross-currency swap is essentially an interest rate swap in which each side is denominated in a different currency. And a currency option is a contract that gives the buyer the right, but not the obligation, to exchange one currency for another at a predetermined exchange rate on or until the maturity date.

24. Product description: Cross-currency swaps
A cross-currency swap is an interest rate swap in which the cash flows are in different currencies. Upon initiation of a cross-currency swap, the counterparties make an initial exchange of notional principals in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. And at the maturity of the swap, the parties make a final exchange of the initial principal amounts, reversing the initial exchange at the same spot rate. A cross-currency swap is sometimes confused with a traditional FX swap, which is simply a spot currency transaction that will be reversed at a predetermined date with an offsetting forward transaction; the two are arranged as a single transaction.

25. What is a credit derivative?
A credit derivative is a privately negotiated agreement that explicitly shifts credit risk from one party to the other.

26. Product description: Credit default swaps
A credit default swap is a credit derivative contract in which one party (protection buyer) pays an periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. The reference entity is not a party to the credit default swap. It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit event occurs.

27. What risks does do the parties to a credit default swap give up and what risks do they take on?
The protection buyer gives up the risk of default by the reference entity, and takes on the risk of simultaneous default by both the protection seller and the reference credit. The protection seller takes on the default risk of the reference entity, similar to the risk of a direct loan to the reference entity.

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28. Product description: Total return swaps
A total return swap is a agreement in which one party (total return payer) transfers the total economic performance of a reference obligation to the other party (total return receiver). Total economic performance includes income from interest and fees, gains or losses from market movements, and credit losses.

29. What risks does do the parties to a total return swap give up and what risks do they take on?
The total return receiver assumes the entire economic exposure - that is, both market and credit exposure--to the reference asset. The total return payer - often the owner of the reference obligation - gives up economic exposure to the performance of the reference asset and in return takes on counterparty credit exposure to the total return receiver in the event of a default or fall in value of the reference asset.

30. Why is derivatives documentation (such as the ISDA Master Agreement) important?
Swaps and related OTC derivatives combine characteristics of loans with characteristics of traded capital market instruments. On the one hand, each swap transaction creates a credit relationship between the counterparties, the terms of which need to be negotiated and documented just as would the terms of a traditional loan. But unlike a loan, the credit exposure is two-way and unknown at the inception of the swap (see above, items 13 – 15). On the other hand, swaps are traded in the market and might involve repeated interaction between two counterparties; renegotiation of credit terms for each transaction would be costly and would act as a drag on trading activity. Consequently, market participants developed the ISDA Master Agreement (click here for a history), which would contain the ‘non-economic’ terms - such as representations and warranties, events of default, and termination events - leaving counterparties free to negotiate only the ‘economic’ terms—that is, rate or price, notional amount, maturity, collateral, and so on. Additional benefits of the ISDA Master Agreement include provisions that facilitate payment netting and close-out netting.

31. Definition: Payment netting
Payment netting reduces payments due on the same date and in the same currency to a single net payment. Payment netting is essentially identical to the legal concept of set-off.

32. Definition: Close-out netting
Close-out netting is a process consisting of three parts. The first is early termination of transactions with the defaulting counterparty. The second is valuation of defaulted transactions under a contract. The third is calculation of close-out amount as the sum of offsetting positive and negative replacement costs. If the defaulting party owes the close-out amount, it can apply collateral posted by the defaulting party and then becomes an unsecured creditor for the remainder. If the non-defaulting party owes the close-out amount, it can in many cases set off the amount against amounts owed by the defaulting party but then must pay any remaining amount to the insolvency administrator.

33. What is the status of an individual transaction under the ISDA Master Agreement?
In jurisdictions where close-out netting is enforceable, all transactions under the ISDA Master Agreement constitute a ‘single agreement’ between the two counterparties instead of being separate contracts. The confirmation of a transaction serves as evidence of that transaction, and each transaction is incorporated into the ISDA Master Agreement.

34. What are commodity derivatives?
Commodity derivatives are agreements that transfer commodity price risk from one party to the other. The basic types of commodity derivative are commodity forwards, commodity swaps, and commodity options.

Definition: Commodity forward

A commodity forward is an agreement to exchange an agreed quantity of a commodity at an agreed future date at a forward price agreed on the trade date. Commodity forwards can be cash settled, which means one party pays the other the difference between the forward price and the price prevailing on the settlement date, multiplied by the agreed quantity. Or they can be physically settled, which means that on the settlement date one party pays the forward price for the agreed quantity and the other party delivers the agreed quantity.

Definition: Commodity swap

A commodity swap is a cash-settled agreement in which two parties agree to a series of cash flows based on an agreed (notional) quantity of a commodity. One party typically pays a fixed price for the notional quantity and the other a floating price. The major distinction between a forward and a swap is that a forward is an agreement on one exchange, while a swap is an agreement on a series of exchanges.

Definition: Commodity option

A commodity option is an agreement, normally cash settled, in which the buyer, in return for payment of a premium, has the right but not the obligation to buy or to sell an agreed quantity of a commodity at an agreed (strike) price on or until a specified (expiration, expiry) date. An option to buy is known as a call option, and an option to sell is known as a put option. Over-the-counter commodity options are often Asian style options.

Definition: Asian option

An Asian style option involves the payment of the difference between the strike price and the average price calculated over a specified period (e.g., one month) prior to exercise (or vice versa), multiplied by the notional quantity. A European style option, in comparison, involves the payment of the difference between the strike price and the price prevailing on the exercise date, multiplied by the notional quantity. Asian options are popular commodity options for end-users because an Asian option is generally a better hedge than a European style option for purchases that occur continually over a month.

35. How do commodity markets differ from financial markets?
Financial markets are distinguished by their time horizon (money versus capital markets) as well as by currency. Commodity markets, in contrast, are distinguished by the underlying commodity.  Further, most major commodity markets are transacted in US dollars. Commodity markets include but are not limited to the following:

  • Energy
    • Petroleum products
    • Natural gas
    • Electricity
  • Metals
    • Precious (gold, silver, platinum)
    • Base (copper, nickel, aluminum)
  • Transportation/freight
  • Others
    • Softs (coffee, cocoa, sugar)
    • Grains, oilseeds, and livestock
    • Weather
    • Emissions
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