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A call option, which is a simple type of stock option that gives the buyer the right (but not the
obligation) to buy 100 shares of a certain stock at a pre-determined price, is a derivative because the
value of the option depends on what the underlying stock does. In the case of GE stock options, for
instance, whether the stock option makes money, loses money, or breaks even depends entirely upon
what General Electric shares do. Thus, the options “derive” their value from GE stock. They are a
derivative.

Farmers in the heartland are responsible for a lot of derivatives in the United States. They often want to
lock in a price for their crops in order to protect their harvest and calculate the profits they’ll make each
season. They work with special brokers or companies to sell futures contracts on commodities
exchanges. These contracts allow them to sell crops they haven’t yet grown or which are not yet ready
for harvest at a predetermined price. The value of these contracts (what the farmer gets paid) depends
on what the underlying commodity does over the period of the futures contract. Again, whether a
futures contract makes money, loses money, or breaks even depends entirely on the price of the
commodity to which it is tied. A coffee futures contract, for instance, “derives” its value from the price
of coffee beans.

The use of derivatives also has its benefits:

• Derivatives facilitate the buying and selling of risk, and many people consider this to have a
positive impact on the economic system. Although someone loses money while someone else
gains money with a derivative, under normal circumstances, trading in derivatives should not
adversely affect the economic system because it is not zero sum in utility.
• Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed
that the use of derivatives has softened the impact of the economic downturn at the beginning
of the 21st century.

Institutional investors have increasingly used derivatives to either hedge their existing positions, or to
speculate on given markets or commodities. The growing popularity of these instruments is both good
and bad because although derivatives can be used to mitigate portfolio risk. Institutions that are highly
leveraged can suffer huge losses if their positions move against them

Derivatives allow risk related to the price of the underlying asset to be transferred from one party to
another.

Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that
has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The
individual or institution has access to the asset for a specified amount of time, and can then sell it in the
future at a specified price according to the futures contract. Of course, this allows the individual or
institution the benefit of holding the asset, while reducing the risk that the future selling price will
deviate unexpectedly from the market's current assessment of the future value of the asset.

Derivatives can be used to acquire risk, rather than to insure or hedge against risk.
Thus, some individuals and institutions will enter into a derivative contract to
speculate on the value of the underlying asset, betting that the party seeking insurance
will be wrong about the future value of the underlying asset. Speculators look to buy
an asset in the future at a low price according to a derivative contract when the future
market price is high, or to sell an asset in the future at a high price according to a
derivative contract when the future market price is low.

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The use of derivatives by Warren Buffett--who once called them "financial weapons of mass
destruction"--is back in the news as the cause of his company's losses.

People have a fear of derivatives as they are at the heart of the recent crash and Buffett has repeated
derided them. So it is not surprising that investors are jumping ship as the Oracle of Omaha has
revealed his extensive use of the instruments.

In fairness, however, what Buffett primarily uses are simple option strategies. He sells puts, and it is
still unlikely that he will take a loss on these long-term positions.

Buffett acknowledged from the start that he might have to show large paper writedowns on these
positions, though his timing in with the majority of the trades was awful, and I am sure those
writedowns are more than expected.

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Wrong

1. Warren Buffett claims that hedge funds do not deserve their fees because these fees could be
the result of a rising tide.

Good hedge funds do not take on market risk (beta); they only get fees for their skill (alpha). Their
clients usually demand that they hedge market risk as a condition for investing in them.

But Warren Buffett's statements appear hypocritical because not only he did he take on significant
market risk, but he also charged a 25% performance fee for the overall increases in the stock
market (a.k.a rising tide).

2 Warren Buffett implies that it's very easy to convince investors to accept a 2-and-20 arrangement. He
had trouble convincing his own investors to accept high hedge fund performance fees and had to entice
them into investing with him by offering some "protection."
3 Warren Buffett implies that the 2-and-20 crowd can attract institutional investors with the snap of its
fingers. The truth is nowhere near this. Most hedge fund investors are sophisticated enough to check
the managers and their track records, and they won't invest with hedge funds unless those funds can
show them they can deliver abnormal returns (or alpha). Warren Buffett had trouble with raising money
in 1956 (he had no track record) and only managed to get funds from family and friends. He now acts
like that never happened

1. 4 Warren Buffett says he is disturbed because a flood of investors are deserting institutional
investors -- who are literally index-huggers -- and going to hedge funds. But back in 1956, Warren
Buffett himself set up his first (hedge fund-like) investment partnership and attracted index-
hugging fund investors. He operated multiple investment partnerships into the 1960s.

S
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derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated
reasons. This pile-on effect occurs because many derivatives contracts require that
a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then
that a company is downgraded because of general adversity and that its derivatives instantly kick in
with their requirement, imposing an unexpected and enormous demand for cash collateral on the
company. The need to meet this demand can then throw the company into a liquidity crisis that may, in
some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate
meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off
much of their business with others. In both cases, huge receivables from many counter-parties tend to
build up over time. A participant may see himself as prudent, believing his large credit exposures to be
diversified and therefore not dangerous. However under certain circumstances, an exogenous event that
causes the receivable from Company A to go bad will also affect those from Companies B through Z.

Possible large losses

The use of derivatives can result in large losses because of the use of leverage, or borrowing.
Derivatives allow investors to earn large returns from small movements in the underlying asset's price.
However, investors could lose large amounts if the price of the underlying moves against them
significantly. There have been several instances of massive losses in derivative markets,
Counter-party risk

Different types of derivatives have different levels of counter-party risk. For example, standardized
stock options by law require the party at risk to have a certain amount deposited with the exchange,
showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on
loans may do credit checks on both parties. However, in private agreements between two companies,
for example, there may not be benchmarks for performing due diligence and risk analysis
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Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as swaps,
forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative
market is the largest market for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of banks and other highly
sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can
occur in private, without activity being visible on any exchange. Because OTC derivatives are not
traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party
risk, like an ordinary contract, since each counter-party relies on the other to perform

Derivatives are used by investors to:

• provide leverage (or gearing), such that a small movement in the underlying value can cause a
large difference in the value of the derivative;
• speculate and make a profit if the value of the underlying asset moves the way they expect
(e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);
• hedge or mitigate risk in the underlying, by entering into a derivative contract whose value
moves in the opposite direction to their underlying position and cancels part or all of it out;
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g.,
weather derivatives);
• create option ability where the value of the derivative is linked to a specific condition or event
(e.g., the underlying reaching a specific price level).

Working closely with our tax practice, our finance and banking specialist able to manage a organize
transactional structure and documentation for variety of trade-finance and structured financial
transactions.

Increasing globalization of the economy has led to greater exposure to both currency and interest rate
risks, therefore, derivatives analysis is essential for hedging the risks. Our finance team consists of
specialists with expertise in providing services relating to the use of derivatives in financial and
commercial transactions and on the offering of over-the-counter derivatives as a banking product.