Many Diversified Financials, Insurance and Banking companies use derivatives to alter the characteristics of assets, to hedge risks and to take bets. This often makes their balance sheets difficult to digest because you can’t take the numbers at face value. For example, an investment bank could disclose zero net exposure to Greek sovereign debt, but in reality, it could have $15 billion in gross exposure and $15 billion in insurance on the exposure, which collectively nets to zero. Other common tactics include altering cash flows via interest rate contracts or hedging currency risk with foreign currency swaps.
At face value, the derivatives market is the largest market in the world. As of November 2011, the estimated notional value of over $707 trillion dwarfs the combined value of the $56.5 trillion global stock market and $98.7 trillion global bond market.1 Considering the complex nature of derivatives, this may seem daunting, but the reality is $707 trillion is a useless number. Here’s why.
The vast majority of the derivatives market consists of interest rate contracts. For the most part, these contracts simply swap cash flows—fixed for variable. There is no risk to principal, and no money changes hands other than the difference between cash flows at the end of the contractual period. The large notional value simply represents the principal amount used to determine the contracted cash flows.
For example, you may want to swap the ...