Wednesday, June 14, 2006 06/14/06-Derivatives

In today's excerpt, one of the most pronounced trends in current financial markets, corporations hedging risk through derivatives, which are sometimes highly standardized and thus exchange- traded, but which are increasingly customized and over-the-counter. This trend is, in many respects, similar to and an extension of the dramatic rise of futures and options in the late nineteenth and early twentieth century. Think trillions:

"...derivatives (are) financial instruments whose values are tied to the performance of assets such as individual stocks and bonds, or to benchmarks such as interest rates. Investors use them to hedge risk. An investor can buy a derivative, for example, to neutralize the effects of rising interest rates or fuel prices, of declining bond values, of swings in the price of a commodity like corn, even the effect of weather on crops.

"...The over-the-counter market is far larger than the exchange-traded ones. Derivatives traded in this market had a total face value of about $285 trillion at the end of 2005, up from about $94 trillion five years before, according to the Bank for International Settlements, an association of international banks based in Switzerland...In comparison, exchange- traded derivatives had a total face value of about $58 trillion at year-end, according to the bank group."

David Reilly, "An Arcane Corner of Finance Creates a London Billionaire," The Wall Street Journal, June 8, 2006, A1, A15


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