Curried Wealth Building
Finding an Edge

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October 5, 2008
 
Issue 10  -  Derivatives 101
 

I have had more than one person ask me for a definition of the term derivatives. It’s not a real simple thing to answer so I put together this short narrative. If anything doesn’t make sense, let me know. currymagic@gmail.com

A derivative is a financial entity that derives its price from some other asset. There are many types of derivatives including options, futures, credit default swaps, and asset backed securities. These products are not priced from their own inherent value but based on the movement in price of other items. The simplest type is a stock option. A stock option is way to bet on the movement of a stock price (a call if you think the price will go up, a put if you think it will go down) without actually buying the stock.

For instance, if a stock like Microsoft is trading at $30 and you think the price is going to $40, you could buy the stock. If you bought 100 shares, this would cost $3,000. The call option is a bet the price will go up. They are sold based on price and time. For instance, an option may have a strike price of $35 and an expiration of March. You may have to pay $1 a share for this right. An option is a right but not a requirement that you can buy (call) or sell (put) a stock at the strike price at any time up until the expiration date. The Microsoft calls would cost you $100 and you would still have the gain for the 100 shares. This is called leverage.

Leverage is one of the main attractions of derivatives. So in the example, if the stock went to $40 as you were expecting by March, you could buy the 100 shares of Microsoft from the option seller. So comparing the two ways to buy the 100 shares of Microsoft.

  1. Bought 100 shares. $3000 output. Sold 100 shares. $4000 input. $4000-$3000= $1000 profit. Total return. 1000/3000 = 33% profit.
  2. Bought Call options $100 output. Bought the 100 shares at $35. $3500 output. Sell the 100 shares. $4000 input. $4000-$3600=$400. 400/100 = 400%-100%=300% profit.

Wow, 300% profit, that’s incredible. But wait, you say, I made $1000 on the first one and you only make $400 on the second, which doesn’t seem very good. What you are failing to see is that if you had invested the full $3000 in options, the profit would have been 30 x $400 = $12000! The option buyer turned his $3000 into $12000. That’s great, what’s the catch? The catch is if the price of the stock doesn’t reach the strike price before the expiration date, you lose everything. A 100% loss in a stock is very unusual. With the stock, it is still belongs to you and could be held longer or be sold at a loss. With leverage comes added risk.

That brings us to what is happening now. I am going to describe just one more type of derivative to give you an idea of what is going on. Credit default swaps are a very widely held type of derivative. Credit refers to bonds or other similar type vehicles wherein you lend money to a government or company and they pay you a set interest rate. Default means to fail and in regards to credit the company or government fails to pay the interest. Along with the interest, you are to get your principal back at some time in the future. So if you buy 10 year bonds from IBM at 7% interest you will receive interest checks for 10 years and then you get your original money back. If IBM fails you lose all your interest and your original money.

In a credit default swap you buy insurance that if the issuer doesn’t pay on the bond that they will make you whole. You are swapping your risk in return for some of your profit. (interest) During the last few years it was very profitable to sell this insurance because very few companies were failing and you were just pocketing premiums as pure profit. Fast forward to today and there are lots of people failing and now the bond or other credit instrument owners are asking to be made whole. Well guess what? The companies who sold the insurance don’t have the money. It truly is a mess. These counterparties are now in danger of bankruptcy. This will lead to huge losses.

There are many other types of derivatives that are MUCH more complicated. So complicated in fact that NOONE may truly understand it completely. Now figure in that there are at LEAST 500 trillion dollars and maybe as many as 1 QUADRILLION dollars worth. These are just so large that we humans can’t really wrap our minds around them. If I gave you a million dollars every ten minutes, it would take about 12 years to give you a trillion dollars. Unbelievably large numbers.

Now that some of these are at risk, there is no way of knowing what will happen. Part of this stems from the fact that a lot of these derivatives are done on the over the counter (OTC) market where the two participants make a deal between themselves without the oversight of any regulating agency. As you can imagine, this makes the outcome even scarier as no one knows what everyone is holding. This is why a lot of banks are afraid to lend to anybody. They are afraid that the other company has a lot of these OTC derivatives that may be worthless and could lead to the bankruptcy of the company. Without transparency in this market, there is no way this current crisis can end and it will get worse and worse. Warren Buffet referred to derivatives as "weapons of financial mass destruction" and he was exactly right.