History and Classfication of Derivatives Essay

History and Classfication of Derivatives Essay

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Classification of Derivatives: Derivatives are classified in terms of their payoffs and as exchange traded and over the counters.
• Linear Derivatives: Linear Derivatives have linear payoff. E.g. Futures and forwards.
• Non Linear Derivatives: Non Linear Derivatives have non linear payoffs. E.g. Options.
• Exchange traded: These are standardized instruments and are backed by clearing house. So there is no default risk. E.g. Futures.
• Over the counters: Over the counters are customized contracts and they bare default risk. E.g. Swaps and Forwards.
The history of derivatives is quite colorful and surprisingly a lot longer than most people think. Derivatives were first instruments developed to secure the supply of commodities and facilitate trade as well as to insure farmers against crop failures. The history of derivatives provides evidence that the first derivatives markets were over the counter (OTC).
Early history of derivative markets in the US:

In 1848: Creation of the Chicago Board of Trade (CBOT) and Creation of the (To-Arrive) contract for grains are formed. In 1865: forward contracts become Standardize. In 1874: Chicago Produce Exchange was created. In 1919: CPE becomes the Chicago Mercantile Exchange. In 1925: First futures clearinghouse was created. In 1922: Futures Act for Grains. In 1936: Options on futures are banned. In 1955: Corn Products Refining Company decision made by the Supreme Court.
Modern brief history of derivatives in the US:
In 1972: International Monetary Market (IMM) for trading currency futures was created. In 1975: first interest rate futures contract create by CBOT. In 1975: Treasury bill futures contract (& options) by CBOT. In 1977: T-Bo...

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...certain cash crunch. if credit rating falls then an institution might lose liquidity and experiences sudden unexpected cash outflows or may some other event that causes counter-parties to avoid trading.
Market Risk: Fluctuation in the prices of that underlying asset cause market risk. This Market risk comprises of four risk factors which include Interest rate risk, Commodity risk, Equity risk and Currency risk. In general risk varies from sector to sector.
Banks use derivatives to hedge against risks that may affect their earnings and other operations which include market risk, counter-party risk interest rate risk and foreign exchange risk.
Farmers use derivatives to lock the price of their crops in order to save their harvest so that they are exposed to price risk.
The importance of derivatives is increasing day by days because of high volatility in the market.

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