This chapter continues the coverage of derivatives, financial contracts whose value depends on the value of some underlying assets or indices. Derivatives are essential to risk management, speculation, efficient portfolio adjustment, and arbitrage. Interest-rate-sensitive derivative securities require a separate chapter, Chap. 21.

Introduction

Many financial institutions take large positions in derivatives. For example, Chase Manhattan held U.S.$7.6 trillion (notional amount) in derivatives as of early 1998 [57]. Trading derivatives can be risky, however. The loss of U.S.$1.6 billion in the case of Orange County, California, led to its bankruptcy in December 1994 and the securities firms involved paying U.S.$739 million in subsequent settlements [527]; the value of an interest rate swap held by Sears in 1997 was a minus U.S.$382 million based on a notional principal of U.S.$996 million [884]; J.P. Morgan in 1997 had U.S.$659 million in nonperforming assets, 90% of which were defaults from Asian counterparties; Union Bank of Switzerland (UBS) wrote off U.S.$699 million because of investment in the hedge fund, Long-Term Capital Management (LTCM).

Four types of derivatives stand out: futures contracts, forward contracts, options, and swaps. Futures contracts and forward contracts are contracts for future delivery of the underlying asset. The underlying asset can be a physical commodity (corn, oil, live cattle, pork bellies, precious metals, and so on) or financial instrument (bonds, currencies, stock indices, mortgage securities, other derivatives, and so on) [95, 470].