Derivatives were created to help banks, investors and corporations, to manage risk. Derivatives are:
Simple Example: Let’s say we go out and I buy you a cup of coffee for $1.00. We agree that the next time we meet, you will return the favor. We sign contracts and everything:)
This is in essence a derivative contract. I bought a future cup of coffee today for a dollar and you agreed to give it to me at any time in the future. If we don’t see each other for five years, or the price of coffee sky-rockets, I will make out quite well! If however, coffee is available out of a tap for next to nothing, I lost my dollar.
Derivatives are just a bet that something will be worth more or less at some point in the future.
The only difference between my coffee example and real derivatives is complexity. There are thousands of different kinds of derivatives that are managed, for the most part, by computers because of their complexity.
There are Different Types of Derivatives
There are two basic types of derivatives, option contracts and forward contracts. These can either be traded on an exchange, or privately. The private ones are the ones that currently have everyone upset!
An option gives the buyer the right, but not the obligation, to buy or sell something at a predefined price, until a specific date. This option normally costs a fraction of the cost of the asset.
A forward contract (Future / Swap) forces the buyer and seller to make a trade on a specific date in the future, and at a set price.
Why are Derivative’s Needed?
They take a lot of risk out of doing business, by spreading that risk to many other people, for a fee. Business’s in this country would be very unstable if they weren’t allowed to stabilize their raw material and currency risks.
Look at South West Airlines as an example. South West, during the period when gas cost $4 a gallon, saw their profits sore because they had established derivative’s that allowed them to buy fuel for $50 a barrel.
Without those derivatives they would have been in the same shape as many other airlines. That definitely would have cost them a loss in profits, but also a loss in jobs.
Derivatives exist for one reason. They are the cheapest way for a company to protect themselves from normally unforeseen risks.
Why are Derivative’s Potentially Dangerous?
You have probably heard the word leverage? Leverage can multiply losses or gains quite substantially. Remember, when you enter into a derivative agreement, you pay a fraction of what the asset costs.
Also, the asset is normally purchased and then sold to the counter party at nearly the same time. Let’s use South West as an example again:
That’s leverage! The chance that you can lose considerably more than you ever invested, or made from the original investment.
Options + Margin = Extreme Danger!
What makes derivatives even more dangerous, is when these contracts are purchased on margin. When you purchase something on margin you are buying it with loaned money.
Because currency movements are so slight, being fractions of a penny. To increase the return on those pennies traders might put up $10,000 as collateral in exchange for $100,000 to invest with. Now if the currency increases by a penny, they made a dime instead.
The problem lies in what happens when prices unexpectedly drop dramatically. Then the guy comes back looking for a repayment of the loan (margin call). Now instead of losing $10,000, you lost $100,000, plus interest!
What are Investment Firm’s Accused of?
Major investment firms are accused of selling derivative contracts that they knew would fail. Kind of like taking out an insurance policy, right before you kill someone.
They supposedly created mortgage backed security pools, that they designed to fail and then bought insurance that would pay out if the mortgages failed. They did and the insurance contracts paid out. That’s why AIG went bankrupt. They were the biggest seller of these insurance products.
That’s All Folk’s
I enjoyed stepping out of the web world for an article. If you liked this article, tell me and I’ll write some more. I was a broker for one of the big investment houses and I can get as technical as you want.
This is all for educational purposes. I do not give advice, nor will I. If you want me to explain the theory behind options, chart patterns, covarience analysis (Big Word!) I’d be happy to oblige.
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