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Derivatives

Derivatives, as the name suggests, are financial assets that are derived from an underlying financial or real asset. One example of a form of derivative that most people are familiar with would be a raffle ticket. Buying a raffle ticket (the derivative) gives you the possibility of acquiring a real asset (the raffle prize). Bets are another form of derivative.

Suppose you placed a bet today (March) on the chances that next Christmas will be a white one, and the bookmaker gave you odds of, say, ten to one. Look ahead to a few days before Christmas and the weather forecasts are talking about a high probability of snow, and the bookmakers are giving odds on. You have the choice of hanging on to the bet and probably winning (although you still might not), or you could offer to sell your betting slip for a guaranteed profit. The bookmaker would probably pay you to close the bet. At the time you took out the bet, your bet (the derivative) was really only worth the amount of your stake. As Christmas approaches and the weather is looking more and more likely to produce snow, your ten to one bet is increasingly valuable and you could trade your derivative and make money without waiting to see if it really does snow.

How derivatives started

In the first place, derivatives were used to reduce the risks associated with farming. A farmer could sell his crop at a fixed price before he’d even planted it. If the weather was good and there was a bumper harvest, market prices would tend to be low. If the harvest wasn't as good, prices would be high. The farmer risks losing money if prices are low and will make a large profit if they are high. If he sells enough of his crop in advance at a price that is better than the worst case but not as good as the best case, he can make sure he has enough money to survive. The corn merchant who buys grain from the farmer has the opposite risks: if the harvest is poor he will have to compete with other buyers, pay high prices, and probably not get as much grain as he needs to survive. He buys enough grain in advance at a price he can afford to ensure he stays in business. If the harvest is good and grain is plentiful and cheap, he would have made more money but at a higher risk. Both the farmer and merchant are hedging by using a derivative, in this case it’s called a futures contract.

Derivatives for speculators

Although the original purpose of derivatives was to reduce risk, they have become increasingly popular with speculators. Derivatives give you the opportunity of taking advantage of the volatility in the prices of real and financial assets at a much lower cost than buying or selling the underlying asset. If you expect to get most or all of the return on your investment as a result of the change in the market price rather than from an income stream, then why not simply bet on the price and forget about owning the asset? That’s what derivatives allow you to do.

It’s the same with horse racing. If you want to make money from a race-horse you have two choices: you can own the horse and collect the winnings (and maybe stud fees), or you can simply bet on it. It is virtually certain that the amount of money placed in bets on a popular race like the grand National will be a lot greater than the value of all the horses running in it, but few of those who bet could afford to buy a horse.

Derivatives are a way of leveraging your money. By buying an option, or futures contract, or placing a spread bet you can take advantage of an expected rise in the market value of the underlying asset for a lot less cost than buying the asset itself. Because derivatives also allow you to profit from a fall in prices as well as rises, you can make money even in a falling market. However, derivatives are much riskier than buying the asset because you stand to lose all the money you have invested (and sometimes a great deal more). A good example of the risks can be seen in the fact that ten years ago, a single derivatives trader (Nick Leeson) brought down Barings Bank. (buy Nick Leeson’s book, Rogue Trader here)

Let’s look at some of the more popular derivatives.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page