Today, and over the foreseeable future, a series of events — call them global megatrends — will have a profound impact on the world economy. Each issue of Point of View will share insight into these trends and how the institutional investment community is preparing to address them.
As investment strategies become more sophisticated, the need to create new investment opportunities and hedge potential risks becomes greater. This need has been driving the tremendous growth of the derivatives markets. Today, derivatives — which are traded on an exchange or in the OTC markets in the form of forwards and futures, swaps and options — are important components of a fluid and efficiently functioning global securities market. Yet many investors still misunderstand these securities.
A derivative is simply an asset whose value is “derived” from the value of some other asset. The size of the derivatives market is most commonly measured in terms of notional value, which is defined as the principal amount used to calculate payments on contracts. Investors’ increasing comfort level with derivatives will continue to impact the size, scope and opportunities that exist with these very important markets.
The global derivatives markets grew at a 21.3% annual rate from June 1998 to December 2006. The notional value of global derivatives grew to US$415 trillion as of Dec. 31, 2006, a 39% increase from a year earlier.
Derivatives are most commonly used in hedging strategies or to generate additional portfolio returns.
No other category of derivative comes close to interest rate contracts in terms of notional value outstanding. These instruments accounted for 69%, or $292 trillion, of total OTC derivatives notional value at the end of 2006. Foreign exchange contracts follow as a distant second at 10%, or $40.1 trillion.
Through December 2006, most derivative types have experienced double-digit annual growth rates in the amount of notional value outstanding. While interest rate swaps dominate the market in terms of volume, credit default swaps have experienced tremendous growth over the past few years.
*Compound annual growth rate is calculated from June 1998 through June 2006, with the exception of credit default swaps, which are calculated from December 2004, the earliest date that data was available.
Source: Bank for International Settlements, Northern Trust