Iowa Sen. Tom Harkin issued a call on Tuesday for regulation of the "over the counter" derivatives market, which has an estimated size of about $596 trillion. By contrast, the value of the world's financial assets—including all stock, bonds, and bank deposits—was pegged at $167 trillion last year by McKinsey. How can the derivatives market be larger than the entire world's financial wealth?
Because the same assets might be involved in several different derivatives. A derivative is a financial instrument whose value depends on something else—a share of stock, an interest rate, a foreign currency, or a barrel of oil, for example. One kind of derivative might be a contract that allows you to buy oil at a given price six months from now. But since we don't yet know how the price of oil will change, the value of that contract can be very hard to estimate. (In contrast, it's relatively easy to add together the value of every share being traded on the stock market.)
As a result, financial experts have to make an educated guess about the total amount at stake in all these contracts. One method simply adds up the value of the assets the derivatives are based on. In other words, if my contract allows me to buy 50 barrels of oil and the current price is $100, its "notional value" is said to be $5,000—since that's the value of the assets from which my contract derives. If you make that same calculation for every derivative and add those numbers together, you get something around $596 trillion—the "notional value" of the world's over-the-counter derivatives at the end of 2007, according to the Bank of International Settlements. ("Over the counter" derivatives refer to contracts that are negotiated between two parties rather than through an exchange.)
But the "notional value" isn't usually a very good representation of what a contract might really be worth to the parties involved, or how much risk they are taking. (And it isn't easily compared with other measures of financial wealth—after all, owning the right to buy $5,000 worth of oil isn't the same as actually owning $5,000 of oil.) Within that $596 trillion are derivatives that effectively relate to the same assets—if you have a contract to buy euros in January and I have one to buy euros in April, we may end up buying the same currency, but its notional value will get counted twice. Moreover, in many instances, the "notional amount" is just a benchmark that never even changes hands—as in the case of the interest-rate swap, by far the most common type of derivative. Likewise, because derivatives are often used to hedge risks, there's a good probability that many contracts in the system essentially cancel one another out.
An alternative way to measure the size of the derivatives market is to calculate the instruments' market value—which refers to how much they would be worth if the contracts had to be settled today. Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate. (That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.)
Still, the concept of "notional value" is not entirely irrelevant. For one, growth in the notional value of all derivatives—which has gone up about fourfold in the last five years—does give a reasonable indication of how fast the market is expanding. And for credit default swaps, a derivative at the center of the current financial crisis, the growth has been especially large—with the total notional amount rising from just $2.69 trillion in 2003 to $54.6 trillion this year.
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Explainer thanks Karsten von Kleist and Carlos Mallo of the Bank of International Settlements, Richard Metcalfe of the International Swaps and Derivatives Association, Kevin Mukri of the Office of the Comptroller of the Currency, and Rene Stulz of Ohio State University.