Derivatives Defined
According to Dictionary.com the term “derivative” means 1. derived. or 2. not original; secondary. In the financial arena derivatives are derived from a basic commodity and can be a portion of that original commodity.
They are essentially contracts between two or more people. You can think of derivatives as ways of “slicing and dicing” financial contracts.
For instance, a normal bond could be broken into two parts. The first part would be the underlying asset itself and any appreciation thereon. The second part could be all the interest due on that bond. This way one investor would get more leverage on the appreciation of the bond while the other investor would get more leverage on the interest component. Theoretically, it could even be divided further with the underlying asset and the appreciation separated from each other as well. Another example is the ability to separate the appreciation above a certain price (the strike price) from the rest of the commodity. So assume that some commodity (or stock) is currently selling for $30. you can sell the appreciation above $35 (if there is any) while still keeping the underlying commodity and any appreciation up to $35. You can also limit this appreciation based on time (i.e. the contract expires at some point).
The definition of a derivative is a security in which the price depends on underlying assets. Common underlying assets are commodities, currencies, stocks, bonds, interest rates and market indexes. Derivatives are often used to hedge risk, for example, a company earning money in Euros, but is using U.S. dollars to purchase a commodity like oil. So it is exposed to exchange-rate risk. To hedge it, the European investor purchases currency futures and locks in an exact exchange rate for future purchase of his oil. Of course he could also use futures to lock in a specific price for the oil (in dollars) as well.
The Risks Inherent in Derivatives
Futures and forward contracts, and options and swaps are all derivatives. Investors do not own the underlying assets, yet they are willing to speculate on the direction of the underlying asset’s price movement under an agreement with another person. As mentioned before, derivatives have risks, however, they are universally accepted as an alternative method of participating in the market. They may be difficult to understand because of their unique language. Each contract or derivative is basing its price, risk and basic structure on a specific underlying asset. The risk of the asset influences the risk of the contract or derivative.
Pricing is a complicated variable. The derivative’s price may be a strike price, meaning the price is ready for an investor to take action. Fixed income derivatives may have a call price, and the issuer can now convert a security. The investor can choose whether to take a long position as a buyer or a short position as a seller.
Three Main Reasons for Derivatives
Derivatives are used for three reasons. Investors may want to hedge a position, or increase the leverage. Investors may also want to speculate on the movement of an asset. Hedging on a position protects or insures the risk of the underlying asset. For example, if an investor owns shares and they want protection in case the stock’s price falls, they will purchase a “put option.” If the stock rises, the investor gains, and if the price falls, the investor doesn’t lose because the put option provides protection against losses.
Leverage is the second reason for derivatives. Leverage has more pull by using a derivative, and is greatly enhanced because of the derivative. If the underlying asset is headed in a positive direction, the movement is enhanced. Derivatives are valuable in the face of volatile markets. High volatility enhances the values of puts and calls.
Trading is the third method of using derivatives, which are bought and sold in a couple ways. They are traded over-the-counter or as an exchange. The OTC contracts are private between parties. An example of an OTC contract is a swap agreement. Unlike exchanges, swap agreements are not regulated, and incur risk because of the private agreement. Exchanges go through an intermediary, the clearing house, and therefore encounter no delivery risk.
Derivatives and the 2008 Crash
The crash of 2008 in the stock market and the real estate market was largely the result of a derivatives market run amok. Prior to 2008 there was a theory that by combining loans into giant bundles you could decrease the risk of any individual default, thus were created CDO’s or collateralized debt obligations. Derivatives were then used to slice these bundles into high risk loans and lower risk loans and then other derivatives credit default swaps (CDSs) were sold to insure against the risk of these “tranches”. The problem resulted when they failed to recognize that if everyone in the tranche was in roughly the same economic situation if one defaulted the others would probably default as well. So those providing the insurance had not calculated the default risk correctly, eventually resulting in a domino effect as the homeowners, then the insurer and then his client were unable to meet their obligations. Michael Lewis provides an excellent description of the events surrounding the crash in his book, The Big Short: Inside the Doomsday Machine.
See Also:
- What is Quantitative Easing?
- What are I bonds?
- What is the Real Definition of Inflation?
- What is the Phillips Curve?
- Disinflation – What is it?
Recommended by Amazon:
- The Big Short: Inside the Doomsday Machine
- When Genius Failed: The Rise and Fall of Long-Term Capital Management
- The AIG Story
- Bailout: How Washington Abandoned Main Street While Rescuing Wall Street
- Predator Nation: Corporate Criminals, Political Corruption, and the Hijacking of America
Brett Chatz was born in Johannesburg, Gauteng, South Africa. He attended the internationally accredited University of South Africa, where he completed the prestigious Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. In concert with the primary degree, he completed several Bachelor of Arts courses, most notably English poetry and literature. In addition he enrolled at the University of Haifa in Israel to complete a post-graduate year in the Bachelor of Arts discipline. Nowadays Brett contributes informative essays for the globally renowned spread betting and CFD trading provider, InterTrader.com
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