The Problem with Derivatives: Dangerous Financial Instruments & Auditing - Warren Buffett

A derivative is a financial instrument which derives its value from the value of underlying entities such as an asset, index, or interest rate—it has no intrinsic value in itself. More from Warren Buffett: https://www.amazon.com/gp/search?ie=UTF8&tag=mg03-20&linkCode=ur2&linkId=f5ac7ba79c18f6b1fe099d62af6f3510&camp=1789&creative=9325&index=books&keywords=warren%20buffett Derivative transactions include a variety of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations of these. To give an idea of the size of the derivative market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.[3] However, these are "notional" values, and some economists say that this value greatly exaggerates the market value and the true credit risk faced by the parties involved. For example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion, the value of the market was estimated much lower at $21 trillion. The credit risk equivalent of the derivative contracts was estimated at $3.3 trillion.[4] Still, even these scaled down figures represent huge amounts of money. For perspective, the budget for total expenditure of the United States Government during 2012 was $3.5 trillion,[5] and the total current value of the US stock market is an estimated $23 trillion.[6] The world annual Gross Domestic Product is about $65 trillion.[7] And for one type of derivative at least, Credit Default Swaps (CDS), for which the inherent risk is considered high, the higher, notional value, remains relevant. It was this type of derivative that investment magnate Warren Buffet referred to in his famous 2002 speech in which warned against "weapons of financial mass destruction." CDS notional value in early 2012 amounted to $25.5 trillion,[8] down from $55 trillion in 2008.[9] In practice, derivatives are a contract between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties.[10][11] The most common underlying assets include commodities, stocks, bonds, interest rates and currencies. There are two groups of derivative contracts: the privately traded Over-the-counter (OTC) derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded through specialized derivatives exchanges or other exchanges. Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[12] Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile. Derivatives may broadly be categorized as "lock" or "option" products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate caps) provide the buyer the right, but not the obligation to enter the contract under the terms specified. Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). This distinction is important because the former is a legitimate, often prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a seductive opportunity to increase profit, but not without incurring additional risk that is often undisclosed to stakeholders. Along with many other financial products and services, derivatives reform is an element of the Dodd--Frank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission and those details are not finalized nor fully implemented as of late 2012. http://en.wikipedia.org/wiki/Derivative_%28finance%29