Learn about Derivatives

by James & Miel on September 23, 2009 · 0 comments

A previously little known financial instrument has made a lot of news lately, as it has become the poster child for those calling on Congress to impose stricter regulations on the kinds of exotic financial structures that contributed to our recent economic collapse. Those financial instruments are of course “derivatives”, a term most people are used to hearing a lot about, but perhaps not something that is well understood by the individual investor.
A derivative is a umbrella term that covers a variety of investment assets. As its name implies, a derivative is a financial structure whose value is dependent on an underlying good or equity. The asset from which the derivative is derived is called the underlying asset.

The most common and basic example of a derivative is a futures contract, where an agreement is made to exchange a commodity at a specified point in time in the future for a market-determined price. A derivative can be based off of anything; from the price of corn to the S&P 500 Index. In addition to futures contracts, common derivative classes are options and swaps.

An option is a contract that allows the holder to buy or sell an asset at a future date. The price at which the sale takes place – referred to as the “strike price” – is set at the time in which the contract is entered. Also set at the time at which the contract is set is the maturity date, a point of time in the future when the contract expires. At any point of time after the contract is initiated but before the maturity date is met, the owner may call in the option, and the transaction contractually must take place.

A swap is a similar maneuver, where two parties agree to exchange cash flows (referred to as “legs”) before a specified maturity date. Again, the swap has a tie-in to an underlying asset. For example, the most common types of swaps are interest rate, currently and commodity swaps. As you can see with both options and swaps, the contracts are tied back in to an underlying asset that determines its value. One of the more controversial derivatives are referred to as complex derivatives, where the derivative is made up of a mixture of options, swaps or futures.

Essentially, derivatives can be thought of as the buying and trading of risk. On one hand, derivatives can be used as a hedging mechanism. In the most common example, a company that drills for oil enters into a futures contract with a company that refines the oil. In this example, both parties are assuming risk and transferring risk. The risk is in the price of oil. Obviously the oil driller wants to sell their oil at the highest price possible, but they are risking the chance the oil prices could drop by the time their product gets to market. Conversely, the oil refiner wants to pay as little as possible for the oil, but they are risking an increase in the price of oil by the time they are able to purchase. By entering in a futures contract that specifies a price at which the oil will sell, each is hedging their risk that the worse case scenario for each will happen.

However, it is clear that one party will benefit, while the other will be hurt (i.e. the market value of the oil will mostly likely be either higher or lower than the price specified in the contract). With that being the case, derivatives are generally considered zero-sum investments, and the benefit and detriment of the contract is equally balanced between each party, and thus the energy sector as a whole (in this example) is not hurt or helped by the end result seen by either party.

On the other hand, derivatives can be considered a speculation mechanism. As is often the case with options, a buyer may enter into a contract betting that the other party is wrong about the direction in which the underlying asset’s value is heading. In those instances, the buyer is assuming a great amount of risk (the option could reach its maturation date without being exercised and become worthless) but if they bet correctly, the payout could be significant. This high risk/high reward structure makes options very enticing to certain individual investors.

But this behavior can hardly be qualified as true investing. It is more like gambling, and should taken very seriously, as the level of risk is high, and the resulting losses can be significant. This fact has prompted Warren Buffet to say the following about derivatives: “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Derivatives are very complex investment vehicles, and I’ve only given a very high level overview of them here. A lot of research has been devoted to them; in fact a Nobel Prize was even awarded to an economist whose work focused on how to price derivatives. When I first started investing, I was encouraged to use options (which I never did), as the person advising me had fallen in love with the high potential profits. However, the associated risk is quite significant, and should be understood before partaking in such an investment.
Twitter: @michael_dink

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