Introduction to Financial Services: Derivatives (CRS Report for Congress)
| Release Date |
Revised Jan. 5, 2023 |
| Report Number |
IF10117 |
| Report Type |
In Focus |
| Authors |
Rena S. Miller |
| Source Agency |
Congressional Research Service |
| Older Revisions |
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Summary:
A derivative is a contract that derives its value from an
underlying asset at a designated point in time. For example,
derivatives may be tied to physical commodities (such as
wheat, cattle, oil, or gold), stock indices, or interest rates. A
derivative’s value fluctuates as the underlying asset’s value
or expected future price changes. Buyers and sellers of
derivatives are not required to own the underlying assets.
Derivatives come in several different forms, including
futures, options, and swaps.
Many firms use derivatives to manage risk. For example, a
firm can protect itself against commodity price increases by
entering into a derivative contract that gains value if the
commodity’s price rises. Southwest Airlines used such
derivatives to implement a price hedging strategy in 2008
that allowed it to buy jet fuel at a low fixed price even as
energy prices reached record highs. When used to hedge
risk, derivatives can protect businesses (and sometimes
their customers as well) from unfavorable price shocks.
Speculators use derivatives to seek profits by betting on
which way prices will move. Speculators may assume risks
that hedgers seek to avoid. Such speculation may add
liquidity to the market but may also concentrate risk
(discussed below). Distinguishing between hedgers and
speculators may be difficult, because a trade may
encompass both speculative and hedging purposes.
Although derivatives trading has its origins in agriculture,
today most derivatives are linked to financial variables,
such as interest rates, foreign exchange, stock indices, the
creditworthiness of bond issuers, and, more recently, the
price of certain cryptocurrencies. In June 2022, the Bank
for International Settlements reported a $632 trillion global
notional value for over-the-counter derivatives.
