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Types of Derivatives securities

Many investors use derivative securities as a way to hedge their investment portfolios against certain risk. A derivative security derives its value from another underlying financial security. Derivative securities come in several types, including forward, future, swap and option contracts. Derivatives are considered sophisticated financial securities, so it is important for investors to understand how they work and the benefits and risks associated with them. Forward Contracts A forward contract is an agreement in which a seller promises to deliver a predetermined quantity of an asset at a certain date and price to a buyer. The price of a forward contract is determined at the initial trade date although the asset is delivered in the future. Most forward contracts are private agreements and are not traded on exchanges. For example, a farmer may enter into a forward contract to lock in the price of wheat if he believes that price will rise in the future. Unlike future contracts, forward contracts are typically made by hedgers who desire to reduce price volatility, so the delivery of goods is almost always made. The risk of default is greater for forward contracts than future contracts. Futures Contracts Similar to a forward contract, a futures contract represents an agreement for a seller to deliver goods at a specified time for a predetermined price. Unlike a forward contract, future contracts are standardized, traded on exchanges and created by a clearinghouse that acts a middleman between the seller and buyer. The benefit of the clearinghouse is that the risk of default is eliminated. The parties of futures contracts are required to post margin, which the brokerage firm uses as collateral. The underlying assets vary and may include corn, wheat, pork bellies, gold, silver, copper and interest rates. Investors are almost always speculators who close the agreement before the maturity date, so goods are likely never delivered. Swap Contracts A swap is a type of derivative security in which investors swap one set of cash flow for another set of cash flow. A currency swap is a common type of swap in which parties enter a contract to exchange streams of cash flow denominated in two currencies. For example, a company based in the United States may need to acquire Japanese yen and a Japanese company may need to acquire U.S. dollars. The two parties can enter into a contract to exchange currency at a predetermined interest rate for a certain amount and on a specific date. Another common type of swap is an interest rate swap, which is an agreement where one stream of future interest rate payments is exchanged for another partys fixed cash flows. Option Contracts Two types of option contracts exist call options and put options. Investors purchase a call option to buy a stock at a specified price and date, and a put option allows investors to sell a stock at specified price and date. Investors of call options realize a profit if the price of the underlying asset rises from the time the contract is initiated. Put option investors profit when the price declines. Option investors are not obligated to buy the underlying asset at the contracts expiration date. The value of an option is determined by its exercise date, time remaining until expiration, the volatility and current market price of the underlying asset and the current interest rate.

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Bretton Woods Agreement

A landmark system for monetary and exchange rate management established in 1944. The Bretton Woods Agreement was developed at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, from July 1 to July 22, 1944. Major outcomes of the Bretton Woods conference included the formation of the International Monetary Fund and the International Bank for Reconstruction and Development and, most importantly, the proposed introduction of an adjustable pegged foreign exchange rate system. Currencies were pegged to gold and the IMF was given the authority to intervene when an imbalance of payments arose. One of the proposals of the Bretton Woods conference was that currencies should be convertible for trade and other current account transactions. Following the end of World War II in 1945, Europe and the rest of the world embarked on a lengthy period of reconstruction and economic development to recover from the devastation inflicted by the war. Although gold initially served as the base reserve currency, the U.S dollar gained momentum as an international reserve currency that was linked to the price of gold.

Definition of 'Pass-Through Security'

A pool of fixed-income securities backed by a package of assets. A servicing intermediary collects the monthly payments from issuers and, after deducting a fee, remits or passes them through to the holders of the pass-through security. Also known as a "pass-through certificate" or "pay-through security." The most common type of pass-through is a mortgage-backed certificate, where homeowners' payments pass from the original bank through a government agency or investment bank to investors.

Luca Pacioli: The Father of Accounting*

In 1494, the first book on double-entry accounting was published. The author was an Italian friar, Luca Pacioli. His impact on accounting was so great that five centuries later, accountants from around the world gathered in the Italian village of San Sepulcro to celebrate the anniversary of the book's publication. The first accounting book actually was one of five sections in Pacioli's mathematics book titled "Everything about Arithmetic, Geometry, and Proportions." This section on accounting served as the world's only accounting textbook until well into the 16th century. Since Pacioli was a Franciscan friar, he might be referred to simply as Friar Luca. While Friar Luca is often called the "Father of Accounting," he did not invent the system. Instead, he simply described a method used by merchants in Venice during the Italian Renaissance period. His system included most of the accounting cycle as we know it today. For example, he described the use journals and ledgers, and he warned that a person should not go to sleep at night until the debits equaled the credits! His ledger included assets (including receivables and inventories),

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liabilities, capital, income, and expense accounts. Friar Luca demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. Also, his treatise alludes to a wide range of topics from accounting ethics to cost accounting. Pacioli was about 49 years old in 1494 - just two years after Columbus discovered America when he returned to Venice for the publication of his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion). It was written as a digest and guide to existing mathematical knowledge, and bookkeeping was only one of five topics covered. The Summa's 36 short chapters on bookkeeping, entitled De Computis et Scripturis (Of Reckonings and Writings) were added "in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business," and to "give the trader without delay information as to his assets and liabilities" (All quotes from the translation by J.B. Geijsbeek, Ancient Double Entry Bookkeeping: Lucas Pacioli's Treatise, 1914). Numerous tiny details of bookkeeping technique set forth by Pacioli were followed in texts and the profession for at least the next four centuries, as accounting historian Henry Rand Hatfield put it, "persisting like buttons on our coat sleeves, long after their significance had disappeared." Perhaps the best proof that Pacioli's work was considered potentially significant even at the time of publication was the very fact that it was printed on November 10, 1494. Guttenberg had just a quarter-century earlier invented metal type, and it was still an extremely expensive proposition to print a book. Accounting practitioners in public accounting, industry, and not-for-profit organizations, as well as investors, lending institutions, business firms, and all other users for financial information are indebted to Luca Pacioli for his monumental role in the development of accounting.

Ginnie Mae
Ginnie Mae is a federally related institution because it is part of the Department of Housing and Urban Development. As a result, the pass-through securities that it guarantees carry the full faith and credit of the U.S. government with respect to timely payment of both interest and principal. It is not technically correct to say that Ginnie Mae is an issuer of pass-through securities. Ginnie Mae provides the guarantee, but it is not the issuer. Pass-through securities that carry its guarantee and bear its name are issued by lenders it approves, such as thrifts, commercial banks, and mortgage bankers. Thus, these approved entities are referred to as the issuers. There are two MBS programs through which securities are issued: Ginnie Mae I program and Ginnie Mae II program. In the Ginnie Mae I program, pass-through securities are issued that are backed by singlefamily or multifamily loans; in the Ginnie Mae II program, single-family loans are included in the loan pool. While the programs are similar, there are differences in addition to the obvious one that the Ginnie Mae I program may include loans for multifamily houses, whereas the Ginnie Mae II program only has single-family housing loans. Fannie Mae and Freddie Mac Although the MBS issued by Fannie Mae and Freddie Mac are commonly referred to as agency MBS,

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both are in fact shareholder-owned corporations chartered by Congress to fulfill a public mission. Their stocks trade on the New York Stock Exchange. The mission of these two GSEs is to support the liquidity and stability of the mortgage market. They accomplish this by (1) buying and selling mortgages, (2) creating pass-through securities and guaranteeing them, and (3) buying MBS. The mortgages purchased and held as investments by Fannie Mae and Freddie Mac are held in a portfolio referred to as the retained portfolio. However, the MBS that they issue are not guaranteed by the full faith and credit of the U.S. government. Rather, the payments to investors in MBS are secured first by the cash flow from the underlying pool of loans and then by a corporate guarantee.