Derivatives

Derivatives provide a means for shifting risk from one party to a counterparty that is more willing or better able to assume that risk. The counterparty's motivation for assuming that risk might be to manage its own risk or to enhance yield (make money). Derivatives transactions may be based on the value of foreign currency, U.S. Treasury bonds, stock indexes, or interest rates. There are four types of derivatives contracts: forwards, futures, swaps, and options. This chapter discusses the following: counterparty credit risk, over-the-counter versus exchange-traded derivatives, shifting risk, types of derivatives, reduction of counterparty risk, suitability as hedging instruments, distinction between forwards and futures, foreign exchange forwards and futures, options, characteristics of swaps, and credit derivatives.