Derivatives Time Bomb

AAA

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.

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  1. Dodd-Frank Wall Street Reform and ...

    A compendium of federal regulations, primarily affecting financial ...
  2. Financial Analysis

    The process of evaluating businesses, projects, budgets and other ...
  3. Risk Analysis

    The study of the underlying uncertainty of a given course of ...
  4. Leverage

    1. The use of various financial instruments or borrowed capital, ...
  5. Derivative

    A security whose price is dependent upon or derived from one ...
  6. Long-Term Capital Management - ...

    A large hedge fund led by Nobel Prize-winning economists and ...
Related Articles
  1. Are Derivatives A Disaster Waiting To ...
    Options & Futures

    Are Derivatives A Disaster Waiting To ...

  2. Taking A Look Behind Hedge Funds
    Mutual Funds & ETFs

    Taking A Look Behind Hedge Funds

  3. Massive Hedge Fund Failures
    Options & Futures

    Massive Hedge Fund Failures

  4. These Financial Products Are Too Complex ...
    Options & Futures

    These Financial Products Are Too Complex ...

comments powered by Disqus
Hot Definitions
  1. Elasticity

    A measure of a variable's sensitivity to a change in another variable. In economics, elasticity refers the degree to which ...
  2. Tangible Common Equity - TCE

    A measure of a company's capital, which is used to evaluate a financial institution's ability to deal with potential losses. ...
  3. Yield To Maturity (YTM)

    The rate of return anticipated on a bond if held until the maturity date. YTM is considered a long-term bond yield expressed ...
  4. Net Present Value Of Growth Opportunities - NPVGO

    A calculation of the net present value of all future cash flows involved with an additional acquisition, or potential acquisition. ...
  5. Gresham's Law

    A monetary principle stating that "bad money drives out good." In currency valuation, Gresham's Law states that if a new ...
  6. Limit-On-Open Order - LOO

    A type of limit order to buy or sell shares at the market open if the market price meets the limit condition. This type of ...
Trading Center