10 common questions about financial derivatives
The usual textbook definition given for derivatives is something like, "instruments derived from securities or physical markets".
Ah! This gets a little difficult, because the term derivatives is not really well-defined. It has become a catch-all generic term that has been used to include all types of new (and some old) financial instruments.Hence, the first lesson we must learn from this is not to generalise about derivatives (i.e. not to say, derivatives are: good/bad, risky, volatile etc.).
The most common types of derivatives that ordinary investors are likely to come across are futures, options, warrants and convertible bonds. Beyond this, the derivatives range is only limited by the imagination of investment banks. It is likely that any person who has funds invested, an insurance policy or a pension fund, that they are investing in, and exposed to, derivatives - wittingly or unwittingly.
The subtle, but crucial, difference is that while shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares in that they are assets).So what? Well, we can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually be fairly standardised and governed by the property or securities laws in an appropriate country.
On the other hand, a contract is merely: an agreement between two parties, where the contract details may not be standardised.
Possibly because it is thought that investors may be wary of the woolly definition of derivatives, one frequently comes across references to "derivatives securities" or "derivatives products". These "securities" and "products" sound fairly solid, tangible things. But in many cases these terms are rather inappropriately applied to what are really contracts.
Due to their great flexibility, derivatives are used by many different types of investors. A good toolbox of derivatives allows the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all combinations thereof. When one reads about derivatives offering the sophisticated management of risk - this is not just marketing hype. They truly do offer the fund management, the insurance and pension industries additional ways to achieve their investment targets.
Well, the corporate brochures would answer (from the above) "sophisticated management of risk " etc. However, in reality the majority of investment is still pretty crude stuff, and the one major attraction of derivatives, the feature that gets people excited, is gearing (or leverage in the US).
Gearing. Simply, the ability for derivatives to soar 100% in a few days, when the underlying security has only risen by a far smaller amount (say 10%). There is nothing magical in gearing. Anyone who has a mortgage is geared to the property market.Let's take the property owner with a mortgage as an example. A person buys a house for $100,000; they put up $10,000 and borrow $90,000 from the bank. Six months later, the house is sold for $150,000. They pay back $90,000 to the bank (for these purposes we will ignore interest payments etc.) they keep $60,000 - not bad for an original investment of just $10,000. The principle is exactly the same in many derivatives investments - big bang for a little buck.
There is the common impression that derivatives are very difficult; and that it is not possible to invest in them unless one has a maths PhD. There is certainly a huge terminological vocabulary that can be daunting. But, in the majority of cases they are investments like any other, you buy at one price and sell at another. Some traders (technical investors) are completely unconcerned about the identity of their investments (for all they care it may be a share, a house, a futures contract or an OTC exotic option), all they need to follow is the price.Hmm. But,That's all very well, but they are more complex than simple shares aren't they? Well, perhaps. But shares themselves are by no means simple, and the forces that move the equity markets are so complex that no-one yet understands them.
Good question. Why would anyone buy something with unlimited, or extreme, downside risk? The answer, going back to question 1, is to be careful of generalisations. The majority of derivatives do have a limited downside risk, just like shares. Some derivatives don't.However, at this point it is important to stress that it is rarely useful to think of shares, bonds or derivatives as single investments, but rather as a component in a portfolio strategy. We can talk about strategies being risky or not, but it is not sensible to label individual investment instruments as such.
If we take the analogy of cars: these can be either safe or risky, depending on who is driving. The majority of accidents are caused by drivers and not by the cars themselves. Certainly, one could say that the potential for harm might be greater with a Ferrari than a small Honda. But, again, the cars sitting in the garage are not dangerous. The danger comes from how you drive them. The same with derivatives, intrinsically neither safe nor risky, but the strategy that uses them might be risky. Just as many share strategies are risky.
Derivatives were certainly the instrument of the collapse. It is almost inconceivable that such a disaster could have been caused by straight-forward share trading by Barings. But, when somebody comes out of a bar at midnight, jumps in car, drives round a bend at 100mph into a tree, it is unlikely that the car would be found to be at fault.Still, to avoid further such mishaps, shouldn't they be banned? It is something to think about. However, it is likely that derivatives have become so enmeshed in modern life that it is nigh on impossible to go back, and remove them. One last reference to cars: cars are dangerous; cars kill; fewer people would be killed if cars were banned. Hence, ban cars?
If one is interested in getting directly involved with futures or options, then the idea "to invest" is inappropriate - they are traded. This implies that one monitors the price more closely, and uses more sophisticated trading techniques (for example, the use of stop orders). There are a number of brokers that specialise in private client futures/options trading, and a list of these can usually be requested from futures exchanges.There are also a number of funds that specialise in derivatives.
However, as mentioned above, whether wittingly or otherwise, you will probably find that you are already investing in derivatives.
The reason is probably that you are equating derivatives with investing in shares or houses. (Have a look again at the answer to question 2 above). The idea of selling shares or a house that you don't own is not an easy one. And quite rightly so, these are assets, which one usually sells only when one holds title.By contrast, derivatives are usually contracts, not assets. So the action of shorting is merely that of sitting on one side of a contractual agreement that 9 times out of 10 will be settled with a mere cash exchange.
The futures/options exchanges are usually very generous with material, and many run special introductory courses. Some brokers may produce special guides and reports for their clients.Some good books to start with would be "Trading In Options" by Geoffrey Chamberlain [Woodhead Faulkner] and "Winning On The Futures Markets" by George Angell [McGraw Hill].
And, of course, don't forget the good ol' Internet. Try a Yahoo (or any of the others) search on "futures", "options" or "derivatives".