Derivatives. They’re controversial, but it seems they’re here to stay. You may have read about them in the news, particularly around the time of the 2008 financial crisis. If you’re curious about derivatives, you’ve come to the right place. We’ll walk you through what derivatives are and how they work. Keep in mind, though, that derivatives trading isn’t usually for the casual investor.
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Derivatives: A Definition
A derivative is a financial instrument that is “derived” from an underlying asset or transaction. Futures, for example, are a basic form of derivative. In a futures contract, a corn producer can agree to sell her corn at a certain price in the future. The other party to the futures contract agrees to buy at that price at the established date.
The risk in the futures contract stems from the fact that one party will lose out, either from agreeing to buy at too high a price or agreeing to sell at too low a price. That original contract can then be sold on to others, transferring the risk.
These days, the derivatives market has expanded and become more sophisticated. It’s a way to make money off of risk without actually purchasing an underlying asset like a commodity, loan, foreign exchange or government bond. Because they’re higher-risk financial instruments, derivatives are generally traded by institutional investors, not retail investors.
In fact, the point of a derivative is to manage risk by offloading it to other investors. Your regular old investor with a 401(k) and some savings in the bank probably doesn’t need to dabble in derivatives trading. To give you an idea of the risks involved, Warren Buffett once described derivatives as “weapons of mass destruction.”
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A credit derivative is a way to transfer credit risk. Remember the Credit Default Swaps (CDSs) that became famous during the 2008 financial crisis? They’re credit derivatives. A CDS is a derivative of a loan (or several loans) between a lender and a borrower. That loan is known as the reference obligation.
The buyer of a CDS (also known as the Protection Buyer) makes regular periodic payments to the seller (also known as the Protection Seller). If the original borrower defaults, the seller of the CDS pays the buyer what is known as a contingency or conditional payment. In a sense, the buyer of a CDS is “shorting” the original loan – betting that the borrower will default. The value of the conditional payment can be a pre-determined amount, or it can equal the difference between the face value of the loan and the amount recovered by the reference entity.
Credit derivatives can be risky business. The buyers of Credit Default Swaps are vulnerable to what’s called counterparty risk. There are two counterparties in a derivatives deal. One counterparty is the entity that is selling (also known as writing) the CDS. They’re the ones who promise to pay the buyer in the event of a default on the reference obligation. But what happens if the counterparty itself defaults? Answer: the buyer is out of luck. And if that happens on a large scale, the effects ripple throughout the financial system, as they did in 2008.
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Another common form of derivative is a call option. The buyer of a call option is buying the right to buy stock at a certain price (the “strike price”) and at a certain date (the “expiration date”). It’s an “option” because the buyer isn’t obligated to the buy stock when the date rolls around. The buyer of the call option is hoping that the stock price will rise beyond the strike price. That way, he or she can buy shares for the agreed-upon price of, say, $100 when the stock is actually worth $120. That’s a win. If the share prices haven’t risen enough to make it worthwhile for the investor to exercise his options, he’s lost the money he spent buying the call options.
The world of derivatives trading exists on a separate plane from the reference obligations that underlie the derivatives. The reference entity (the company, government or other institution that issues a loan) doesn’t necessarily know about the goings-on in the derivative of that loan. The reference entity’s credit risk on the loan is transferred to the derivatives market, where it can be traded freely. The seller of the derivative is selling the risk on the reference obligation. The seller and the buyer have a whole new contract. In the event of a default or other credit event, if the reference entity can’t pay up, the seller of the derivative pays the buyer.
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For the purpose of being a well-informed citizen, it’s important to know what derivatives are and how they work. But that doesn’t necessarily mean you should rush off and invest in derivatives yourself. As an individual investor without a high level of expertise and cash, you might find you are better off leaving the derivatives markets to the professionals.
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