Deep Dive – Personal Finance – Derivatives

In a letter to his shareholders in 2002, Buffet wrote, “In our view…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

And as if that were not enough, the Vatican recently dubbed them asa ticking time bomb.

At their core, derivatives are really not that complicated. A derivative is simply a security (or “piece of paper”) whose value is “derived” from the price of something else. Wikipedia, that repository of wisdom, defines a derivative as a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate. The derivative’s price is determined by fluctuations in the underlying asset. The most common types of derivatives are futures, options, forwards and swaps.

Let’s unpack that, shall we?

Imagine a market where common folk, like you and I, have differing opinions on where stock prices are headed. The optimists expect prices to go up while the skeptics think the prices will fall. In market parlance, the optimists are called bulls, and the skeptics are called bears. Based on our assessment of market trends, we take our positions- bullish or bearish. This is what forms a typical Derivative Market.

As we’ve discussed earlier, Derivative indicates that the financial instrument derives its value entirely from the asset it represents, whether that is equity, bullion, currency, commodity, realty, rate of interest or even livestock. A feature that is common to all underlying assets is that they carry the risk of change in value. The price of a stock may fall or rise, as will commodity prices and interest rates, while a currency can weaken or strengthen relative to other currencies., Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security. Many companies use derivatives as a hedge against payments to be received or made. For instance, an exporter receives his payment in foreign currency. He will suffer a loss if the rupee strengthens, which conversely means that the foreign currency will weaken. An importer has to make payments in foreign currency. He will suffer a loss if the foreign currency strengthens, because that means he will need more rupees to buy the same amount of foreign currency.

When you invest in derivatives, you are basically betting on whether the value of the underlying assetwill increase or decrease within a set time frame. When you deal in derivatives, you are buying a promise from the original owner of the asset to transfer ownership of the asset rather than the asset itself. This promise affords you great flexibility and is the most important trait that appeals to investors.