Derivatives are financial instruments whose values depend on the values of other assets such as stocks, bonds, and commodities. Firms, banks, and investors can use derivatives to hedge various kinds of risks. However, derivatives can also be used for speculation, and consequently they can magnify the degree of risk-taking that market participants engage in. Trading in derivatives reached tremendous levels before the recent financial crisis, and that burst of activity received a great deal of criticism later, reflecting perceptions that risk-taking by financial institutions was excessive and that derivatives helped to elevate considerably the severity of the crisis.
There are two major types of derivatives markets: exchange-traded and over-the-counter (OTC). In contrast to the heavily regulated exchange-traded market, the OTC market is bound by little regulation and offers customized derivative products. Those features enable it to provide greater flexibility in terms of meeting individual investors' hedging and speculation needs. As a result, the OTC market is much larger than the exchange-traded market. For example, as of December 2010, the notional amount outstanding (the gross nominal value of all deals) in the entire OTC market, excluding commodity contracts, was $598 trillion, nearly nine times the amount outstanding in the exchange-traded market (S68 trillion).
A look at recent trends in the global OTC derivatives market reveals that the market has stayed generally flat since trading volume fell significantly at the peak of the financial crisis. Although foreign currency derivative contracts have started to increase, and interest rate contracts have recovered to pre-crisis levels, trading in equity and commodity derivatives and credit default swaps continues to stay low and, in some cases, it has further declined.
Prior to the financial crisis, the global OTC derivatives market grew strongly and persistently. Over the ten-year period from June 1998 to June 2008, the market's compounded annual growth rate was 25 percent. The total notional amount outstanding reached its peak of $673 trillion in June 2008, but just six months later it had fallen to below $600 trillion in the wake of the financial crisis. Since then, the market has stayed about 10 percent-13 percent smaller than it was at its peak. In December 2010, the total notional amount outstanding was $601 trillion.
While the notional amount outstanding measures the size of the derivatives market, the gross market value provides an estimation of market risk, that is, the potential for gains or losses from derivative transactions. Gross market value had an upward trend over time until 2008: It stayed around $2 trillion-$3 trillion during 1998-2001, increased to $6 trillion-$7 trillion during 2002-2003, grew to around $10 trillion during 2004-2006, reached $16 trillion in 2007, and finally rose to $35 trillion at the end of 2008. As the derivatives market experienced its first and biggest drop in size in December 2008, the risk level ironically increased to its historical high, which indicated how vulnerable and dangerous the market was then. By December 2010, the gross market value came down to $21 trillion, 40 percent lower compared to two years before. Yet, as a risk measure, it still seems quite volatile, ranging from $21 trillion to $25 trillion during the past two years.
There are six main categories of derivatives: foreign exchange, interest rate, equity, commodity, credit default swap, and other.
Foreign exchange contracts have the second-highest notional deal value among all types of derivative products. …