The financial crisis and resulting new regulations are focused around Wall Street as a a whole, but there are specific regulations designed to curb the appetite for risk investors seem to have unlimited supplies of. Derivatives are going to be more highly regulated as investment tools now, though they were already regulated before. The purpose of this post is to point out that derivatives have value in the marketplace, but we should first talk about what derivatives are.
A derivative is a type of investment that is usually some kind of contract based around a particular asset. The most well known derivative is an option. One type of option is a call option. You can buy a call option and it’s value can go up or down based on the prevailing forces surrounding the asset it’s based on. An example will provide more detail.
Say you want to buy stock in Apple because you think the price of the Apple shares will increase. But you know that stock may fall and you don’t want to lose that much money on your investment. You could purchase a call option. If Apple is trading at $275 you might buy an option to purchase Apple stock at $280. To purchase this option you might pay $5. The benefit to you is as the owner of the option you have the right to exercise it whenever you want. So if the stock goes to $300 then you can exercise the option and buy Apple at $280 and it’s already worth $300. Who would sell the stock to you at $280? The guy on the other side of the option has to because of the contract, plus he collects his $5 fee. But he gets that fee whether you exercise the option or not.
There is no limit to the types of derivatives you can get involved in. The most common types are options (a call option being one of them), futures contractions, and swaps. You may remember swaps from credit default swaps. But today is not the day to go into detail about derivatives.
Many people get involved in derivatives because the return per dollar of investment can be much greater than the same investment in the underlying asset. Many sophisticated investors get into derivatives as a way to make more money, and it’s no surprise hedge funds and the proprietary trading operations of banks got involved in them. But some people argue that investors shouldn’t be allowed to get involved in many of these contracts. You can count myself among those people.
A common derivative is the futures contract (note to more knowledgeable investors, we aren’t going to talk about differences between futures and forwards today). It is a simple contract that requires Party A to purchase an asset from Party B at a set price at a set time in the future. It’s common in agriculture. So I might contract with you to purchase a ton of cotton at $1 per pound 3 months from now. This provides you as a cotton farmer the pricing stability you need to make sure it’s worth your time to farm the stuff, and it allows me (as a t shirt maker or something) to plan ahead with my expenses. Other businesses such as airlines use derivatives to stabilize their fuel costs. They might by oil contracts that increase their investment returns when oil prices spike. So they make less on ticket sales but more on the investments. Shareholders like stability.
But some people abuse the derivatives market. I really don’t think I have any business buying coffee futures because I think I can make a buck. My getting into that market may just distort things. But that doesn’t make these investments bad. I think they’re just for people that really play in these markets.
Photo: flydime
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
