An Overview of the Literature about Derivatives

A derivative is defined by the BIS (1995) as “a contract whose value depends on the price of underlying assets, but which does not require any investment of principal in those assets. As a contract between two counterparts to exchange payments based on underlying prices or yields, any transfer of ownership of the underlying asset and cash flows becomes unnecessary”. This definition is strictly related to the ability of derivatives of replicating financial instruments2. Derivatives can be divided into 5 types of contracts: Swap, Forward, Future, Option and Repo, the last being the forward contract used by the ECB to manage liquidity in the European inter-bank market. For a further definition of contracts, which should although be known by the reader, see Hull (2002). These 5 types of contracts can be combined with each other in order to create a synthetic asset/liability, which suits any kind of need; this extreme flexibility and freedom widely explain the incredible growth of these instruments on world financial markets. In section 2 I will look at some micro-economic results about derivatives; in section 3 the issue of risk is addressed; in section 4 monetary policy results about derivatives are shown, and in section 5 fiscal policy results are shortly presented. In a brief statistical appendix some relevant data are presented.