Saturday, September 27, 2008

A Note on Derivatives: Size of the Market

Much has been written about the size of the derivatives market. According to the Bank of International Settlements, the notional amount of over the counter derivatives outstanding was $596 trillion on 12/31/07. However, unlike conventional securities markets (or even exchange listed derivatives), market conventions do not include an embedded netting mechanism. For example:

Suppose a speculator believes that interest rates will move higher. The speculator may choose to sell a Treasury note short. If interest rates do move higher, the speculator can buy the Treasury back at a lower price and pocket the difference. On the other side of the trade, another participant initially goes long and will sell the note back to the speculator.

At the end of the trade, both parties have a zero position and one party collects a profit.

The speculator could also pay fixed in an interest rate swap to achieve a similar exposure to selling the note short. The difference is that the position is frequently closed by entering into a new, but principally offsetting, position. Periodically, the dealer community will net positions together and transfer payments based on the net present value of the trades. But at any given time, the number of contracts outstanding may not be an accurate reflection of an institution's risk.

This short post does not do the topic justice, please drop me a line if you would like to discuss further.

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