Derivatives Time Bomb

DEFINITION of 'Derivatives Time Bomb'

A possibile situation where the financial markets plunge into chaos if the massive derivatives positions owned by hedge funds and the large banks were to move against those parties.

Institutional investors have increasingly used derivatives to either hedge their existing positions, or to speculate on given markets or commodities. The growing popularity of these instruments is both good and bad because although derivatives can be used to mitigate portfolio risk. Institutions that are highly leveraged can suffer huge losses if their positions move against them.

BREAKING DOWN 'Derivatives Time Bomb'

A number of well-known hedge funds have imploded in recent years as their derivative positions declined dramatically in value, forcing them to sell their securities at markedly lower prices to meet margin calls and customer redemptions. One of the largest hedge funds to collapse in recent years as a result of adverse movements in its derivatives positions was Long Term Capital Management (LTCM).

Investors use the leverage afforded by derivatives as a means of increasing their investment returns. When used properly, this goal is met. However, when leverage becomes too large, or when the underlying securities decline substantially in value, the loss to the derivative holder is amplified. The term "derivatives time bomb" relates to the speculation that the large number of derivatives positions and increasing leverage taken on by hedge funds and investment banks could lead to an industry-wide meltdown.