Oh no here come the financial concepts, time to clear the cob webs we are going to talk about derivatives. Want to sound smart at work today, drop the word derivative in some random sentences and wait for the looks you get.
This is how my wife fell in love with me. Except this was back in college and I was a Chemistry major at the time. I started dropping some names of the elements off the periodic table and the rest is history.
What is a derivative?
What does the word mean, let’s take the root, derive. Derive means to have origins in something else. The lakes name was derived from ancient Mayan mythology. With that said the derivative in the financial market is a security whose underlying asset determines the price. Fluctuations in the value of the underlying asset (stock, bonds, currencies, market indexes) determine the price of the derivative. You are betting whether you believe the price of the underlying asset will increase in price or decrease in price by a certain amount over a certain period of time. Generally speaking, a derivative is often very risky; if you are risk adverse you may want to proceed with caution.
Why derivatives and how are derivatives used?
The question is why not, they are used for speculative purposes; remember the name of the game is managing risk. Remember the other day when you were reading my article about Beta? Alright go take a look, I will wait for you! We are using the derivatives as a hedging maneuver to reduce the risk of our portfolio.
Types of Derivatives
The list is quite long for the list of derivatives; I could go on for weeks explaining all of these. Common types of derivative contracts are: forwards, futures, options, warrants, swaps which then is broken out into interest rate and currency swap. The title of the article is one of the varieties of the options.
Example of Derivatives
If you are still following along let’s take a look at an example: British company buying shares of (TTaTM) This That and The MBA off the NYSE using a stack of Benjamin Franklin’s! This company is exposed to fluctuations in exchange rates between the nations. To try to minimize the impact (hedge) of these flucations the British company would purchase currency futures. This is a maneuver to lock in a particular exchange rate for any potential sale of the underlying stock of TTaTM, and the currency conversion back into Euros, the currency to which the British company prepares its financial statements. That scenario we minimized the currency exchange rate fluctuations, if the British company wanted to invest in my company without the options contract they would be exposed to the volatility of my stock along with the volatility of the exchange rates.
Any questions class? What do you think? I know we are Personal Finance bloggers, but has anyone had the privilege of working with options contracts? Care to share a story or two?
Wow… I definitely learned about something I’ve never heard of before! I don’t know too much about the stock market or investments so I love reading posts like these.
Since derivatives are quite risky, who typically invests in them? …Companies perhaps? Could/should an individual investor consider it for his portfolio?
@ GB – savvy investors and companies doing business in foreign land utilize currency derivatives. The long and short of it is many use options contracts as part of their portfolio. Generally these people are more active in their portfolios than the average investor. I dont want to bore you to death, but they are just another investment tool in the arsenal that you can use to mitigate risk, or you can use it for speculative purposes (bet) against the underlying security fluctuating down or upward.
Maybe it’s because I haven’t had a coffee this morning, but I’ve always been confused about derivatives and I think I am still am right now.
Clearly, it’s something wrong with me–as I am still awaiting for my proverbial “ahah!” moment.
@ Frugal Fries- I talked about hedging in the article, think of hedging as mitigating risk or like an insurance policy. In the example that I used, we want to protect ourselves from exhange rate fluctuations Example: $ 1 Us Dollar = 2 Euros today but in 2 months it may be $1.00 Dollars = 4 Euros, If we had $1,000 US Dollars back then we would have had 2000 Euros. If we exchanged our money in 2 months from USD to Euros we woul exchange our $1,000 but instead of getting 2,000 Euros we received 4,000 Euros. With that said the value of the Euro went down or the value of the US Dollar strengthened. This is exchange rate risk, we would buy a derivative to protect ourselves from the declining value of the Euro. You do not want to make money in the US then to realize once you change it back into the Euro that you have lost money, thus you use a derivative as a form of insurance to protect against that. Hope that helps. Did I confuse you more? Have you had your coffee? 🙂
I’ve read a little bit about derivatives, but it still a concept that is still foreign to me. I understand terms like futures, options, and warrants mostly because I wrote a blog post on buying gold. Otherwise, I’m one lost puppy. But, I’m still trying to learn.
@ Anthony – there is so much more that I could talk about but, I am sure some are already struggling to make it through the article. I would like to keep some readers…lol..I will let you know how my stats are tomorrow, if anyone has jumped ship.
Aren’t derivatives what got the U.S. housing market in such trouble on mortgages when the whole housing crisis started?
@Photon0312 – Yes, mortgage backed securities (MBS) was a culprit and also lenders lending to people who otherwise couldn’t afford the transaction that they were entering into. This is where FannieMae comes into the picture of this whole mess. They were selling the securities in the secondary market, which is typically bought by hedgefunds. Panic struck, and noone knew exactly what was in the MBS so the secondary market shut down. The trickle down effect, lenders then stopped lending…there was a surplus of houses and house values declined…and then here we are today trying to work our way back out of this mess!
Derivatives are always confusing for to understand. I would love to see articles on Derivatives trading tips 🙂
@ Karunesh – I will definitely look into doing one of those articles. The topic can get really deep really quick, so I tried giving a high level view of it now.