What Are Financial Derivatives?
A Tool That Takes Small Investments Can Produce A Very High Payoff
Sep 17, 2009
Consider an investor with limited resources contacts several owners each of a fruit press. The investor speculates that there will be a good market for oranges at the end of the year. He offers to pay the owners of the fruit press 100.00 to use their press in the future. They don’t know whether the orange market will be a good one or a bad one.
If it is a bad one, no fruit farmer will use their presses. If it is a good one, then the presses will be used. But the press owners don’t know. Neither does the investor, but he bets that they will be needed. Some of the press operators take the investors money, and a contract is made up to use the press if the investor wants to use it. The press owner can’t rent out the presses to others.
When the end of the harvest comes around, the harvest is very poor. No one needs the press. So the investor loses his money. The farmers didn’t lose any money other than the cost to run the orchard but didn’t make any either because their harvest was poor. The press owners made money by the contract with the investor, but not anymore.
If instead the harvest was good, then the investor charges whatever he wants for the use of the press. The press owners don’t get any more money. The orchard farmers pay whatever the investor charges. By exercising the contract, an option to use the presses or not, the investor made money.
This is an example of a derivative in action. It is about leverage. By using a small amount of money to control an asset that has a lot of value the investor has leveraged that money to make a lot more in the future.
Can Derivatives Be Hurtful?
In 1995 a trader Nick Leeson of the Barings Bank of England caused the failure of the bank. He was a derivatives trader whose trades did not work out, and due to the enormous leverage of the trades used, the losses became so large that the bank was bankrupt when the results of his trades become due. (In the example above, because the investor had arranged with the press operators to pay for the use of the presses, regardless of the good or bad harvest, he would be obligated. If the harvest was bad, he would still be legally obligated to pay the press owners.)
Derivatives are Used to Control Risk
Risk-management and gambling may look similar, but they are different. Consider once again the case of the investor; what would happen if the investor in the example did not know anything about the orange orchard business? If such an investor merely went out without studying the underlying economics of oranges and what the potential for demand would be in the future, that would not be risk management but gambling.
On the other hand, if the investor went out and looked at forecasts about the supply and demand for oranges and how many presses would be needed, he is managing the risk he is taking with regard to buying the rights to use the presses. He would still be obligated to pay for the right to use the presses, but he is forecasting that there will be a lot of demand for the presses, and he will make money.
Examples of Financial Derivatives
There are many types of derivatives, here are some of the most common.Options represent the right, but not the obligation, to buy or sell a security or other asset during a given time for a specified price.
- Forward Contracts involve the purchaser and the seller where both are obligated to trade a security or other asset at a specified date in the future.
- Futures are like forward contracts because they represent the right to buy or sell a standard quantity and quality of an asset or security at a specified date and price. Futures, however, are regulated and traded on an exchange.
- Stripped Mortgage-Backed Securities represent interests in a pool of mortgages, called "Tranches," where the cash flow has been separated into two components: interest and principal.
- Interest only securities, or "IOs," receive the interest portion of the mortgage payment. They generally increase or decrease in value as interest rates rise or fall.
Financial Derivatives are designed to manage risks; but the pool of risk associated with them must be well understood. These tools can quickly create a lot of wealth for individuals, but just as quickly, if not managed properly, can cause loss.
 |
 |
