Under U.S. law and the laws of most other developed countries, derivatives have special legal exceptions that make them a particularly attractive legal form for lending. However, the strong protection of creditors afforded to derivative counterparties, combined with their complexity and lack of transparency, can lead capital markets to outsource credit risk. This can contribute to the credit boom and increase systemic risks. Indeed, the use of derivatives has helped to conceal credit risks against third parties and to protect counterparties on derivatives of the 2008 financial crisis in the United States. On January 1, 20X1, Entity A entered into a service agreement with Entity B. Entity A is due to pay 20X1 to entity B on October 1. The functional currency of the two companies is EUR and USD does not meet any of the conditions of IFRS 9.B4.3.8 (d) and the embedded derivative must therefore be separated from the host contract. The EUR/USD futures price for October 1st is 1.1 (EUR 1 – USD 1.1). Imagine, for example, a European investor whose investment accounts are all denominated in euros (EUR).
This investor buys shares of a U.S. company through a U.S. exchange with U.S. dollars (USD). Now the investor is exposed to foreign exchange risk while holding that stock. Exchange rates are likely to see the value of the euro rise against the USD. If the value of the euro rises, all gains made by the investor on the sale of the stock become less valuable if converted into euros. Most derivatives are exchange-traded (OTC) beyond the counter (OTC) and are securities transactions between two counterparties executed outside official exchanges and without prudential supervision. Over-the-counter trading is done in over-the-counter markets (a decentralized location without physical location) through distributor networks.
However, some contracts, including options and futures, are traded on specialized exchanges. Among the largest derivatives exchanges, the CME Group (Chicago Mercantile Exchange and Chicago Board of Trade), the Korea Exchange and eurexEurex ExchangeThe Eurex Exchange is Europe`s largest futures and options market. It mainly trades European derivatives. This stock exchange has a wide range of trading relationships, ranging from European equities to German debt. Another type of influential derivative is a futures contract. The most used are commodity futures. The main ones are oil price futures. They set the price of oil and, ultimately, gasoline. A swap is a derivative instrument in which two counterparties exchange the cash flows of the financial instrument of one party against those of the other party. The benefits in question depend on the nature of the financial instruments involved. In the case of a swap with two debt securities, the benefits in question may be periodic interest payments (coupons) related to these bonds. In particular, two counterparties accept the exchange of one cash flow over another.
These flows are called „legs“ of the swap. The swap agreement defines the data on which cash flows must be paid and how they are anticipated and calculated.