Derivative Products
LexInter | June 9, 2015 | 0 Comments

Derivative Products

The derived products

Definition of derivatives

Derivatives are financial transactions based on transactions that are derivatives   of other transactions. Derivatives are the subject of markets, derivatives markets.

Derivatives are contracts whereby agents fix in advance the price at which they can buy or sell a certain amount of the underlying asset .

Derivatives are financial assets that consist of forward rights or contingent rights resulting from contracts or promises of contracts. They are linked to underlying assets or indices and their value depends on the evolution of these assets or indices between the conclusion of the contract and its unwinding. The value of the product is thus derived from that of the underlying assets. The underlying assets can be, for example, an interest rate , a currency and its exchange rate, a transferable security and its value, a commodity and its value, an index .

These products were developed as hedging instruments, but they have evolved and are used to take speculative positions.

The evolution of derivatives

The first contracts were for raw materials.

From the 1970s, contracts focused on standard financial products: equities, interest rates, exchange rates Derivatives were thus based on financial assets consisting of forward rights or conditional rights resulting from contracts or promises of contracts for other existing financial products.  The  underlyings can thus relate to the foreign exchange market ( currencies ), the stock market ( equities for example) or the commodity markets.

The early 1980s saw the introduction of the first index derivative contracts . In index contracts, there is no longer an effective delivery, if any, of the asset which serves as support. Positions still open give rise to a cash settlement based on the difference between the liquidation price of the spot index and the last clearing price (in the context of forward contracts ) or the strike price (in the case of optional contracts ).

Financial innovations have created increasingly complex derivative products. From simple, so-called vanilla-based products, financial innovation has shifted to  so-called “exotic” or second or even third generation products. The development is done around two axes: transformation of the characteristics of the contracts and extension of the nature of the underlying .

Financial innovation is particularly active in over-the-counter markets (OTC markets). New contracts were ever created, with increasingly strange original payments clauses: Asian options, barriers, digital, etc .

All kinds of derivative assets were created, using as support anything that is objectively measurable. Derivatives were thus created concerning both microeconomic and macroeconomic risks. The “financial engineers” have developed contracts on inflation, unemployment, volatility of stock markets, temperature, the strength of earthquakes (Richter index), the number of goals scored during a competition of football, etc . GDP growth, inflation, the number of jobs created, the price of real estate. It may be indices, but also the volatility of indices, crossing of thresholds (ceilings or floors) of variation in a tunnel or outside.

These products, given this development, pose ever more complex problems of standardization and valuation of contracts.

The nature of derivative products

Derivatives are forward financial instruments within the meaning of Article L 211-1 of the Monetary and Financial Code.

Derivatives have been presented as instruments allowing optimal risk allocation. Their development has been associated with the affirmation of increased market efficiency and the rise in market prices as the result of an improvement in the economy that they would have helped to generate.

In practice, we see that derivative products promote the volatility of the underlying markets. There have been several resounding debacles, directly implicating the excessive use of derivatives and leverage.

The complexity of products and the concentration of risks are themselves sources of risk due to the frequency and magnitude of tail risks, increased uncertainty and the increased possibility of systemic risk.

The derivatives market is very profitable for banks. These are often high value-added operations generating the highest margins. It is also very profitable for market companies: more than a third of the turnover of Euronext or Deutsche Börse comes from the trading of derivatives.

The dangers of derivatives

Supposed to allow better management of existing risks, derivative products actually generate new risks The destabilizing effect is in particular linked to the fact that the derivative markets encourage agents to choose riskier strategies, and that the use of these products not only on a speculative basis but even as a hedge leads to an increase in volatility. .

 The derivatives have been described by Warren Buffet as ” weapons of mass destruction “. The financial crisis resulting from the subprime crisis shows that derivative products create a systemic risk.









Case law: Derivatives transactions and bank bonds



Derivatives are forward financial instruments within the meaning of Article L 211-1 of the Monetary and Financial Code.

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