Thursday, April 29, 2010

Information Request

I like to think I'm the smartest person I know... but I'll be damned if I can't figure out what a derivative security is. I pledge a six pack to whoever can explain what such a thing is. (And I've read all the online definitions... so above and beyond those, if you please.)

Mr. Phil graces my comment section with his wisdom... and I'm the smarter for it. And yes... I sent him $10 via PayPal. But no... I can't say whether he spent it on beer or not.


Teacher Phil said...

A derivative security is any investment that (1) can be bought and sold (2) the value is determined by the movement of a currency, stock, bond, interest rate, or anything. For example, if I was selling a chicken farm and you wanted to buy it, I could sell you and option to buy my chicken farm at $400,000 in 6 months and you'd pay me $5000 for the option. The option is now worth $5000 and it can be sold to another person. The option is a derivative security.

Jungle Jil said...

Okay Phil, so the $5000 value of this derivative security goes up or down based on the perceived future value of the chicken farm, correct? If the $400,000 farm price is determined to be too low, then the value of the derivative will go up because it's a good deal?

Are all derivatives time limited? Do they always expire, or can they be set to some fixed distance into the future... 6 months from today, tomorrow, and so on?

Does the ownership of this derivative require one to purchase the chicken farm if one is in possession of the derivative when it expires, or is that an option? What becomes of the derivative in that case?

Thanks for helping to educate me! Send your PayPal address to me at, and I'll send you $10 for that 6-pack.

Teacher Phil said...

Let's say your neighbor sold his chicken farm for $500,000. now your option is worth $105,000 roughly. The option is now "in the money". Let's say your neighbor sells his farm for only $300,000. Now your option is worthless, but it has only speculative value of say $100. It is now 'out of the money'.

Options expire unless you create them to be infinite. All derivatives are contracts written under contract law, and they are customized to the creator of the contract.

2 types of options; American-style (you can exercise the option any time before expiration) and European-style (you can only exercise the option upon expiration date). Exercise = buy the chicken farm.

The price of the option, over and above the trading price of the farm, is called 'time decay'. A $400,000 farm with a $400,000 option trading at $5000 has $5000 of time decay.

The option expires on expiration if not exercised. If exercised, the option disappears.

Options and 'rights' are the same thing basically

Futures are mandatory requirements to buy stuff. Lets say you need to buy corn to feed chickens. You can buy $100,000 of corn in the futures market for Dec 2012 delivery at $5.00 a bushel. On that date if you still hold the futures option you will be required to fork out $100k and the market is required to deliver corn. in reality, a cash settlement is made in your brokerage account, rather than physical delivery. This is called hedging. You can 'hedge' the price of corn so you know your costs later. Similarly, if you are a corn farmer you can sell futures to lock in a future price of $5 for Dec 2012 if you have already bought your diesel etc and you know your costs.

'Swaps' allow you to trade payments. If you borrow $400,000 to buy your farm in PHP, you can go to Goldman Sachs to make USD interest payments. Goldman will find a person who wants to borrow USD and pay PHP interest payments. Goldman charges a fee and you get to pay USD interest on your PHP loan. This is a way to speculate on the direction of currencies.

CDS credit default swap. These are insurance on loans. Lets say the bank lends you $400,000 but they are unsure if you can pay. They go to AIG and get insurance. the bank will pay maybe 1% of the loan every year and AIG will make payment of $400,000 to them if you default. Similarly, Goldman Sachs can go to AIG and buy insurance on your loan without even lending you the money. When your farm mysteriously burns to the ground GS can collect the $400,000 when you default on the debt. CDS also called CDO Credit Default Obligation.

Jungle Jil said...

Phil, thanks so much.

Just one last set of questions: The original reason why I wanted to know this information.

The new Congressional financial regulations try to cut down on derivatives. Warren Buffet doesn't like that idea.

(1) How do you make big money in derivatives, (2) how are they dangerous or how can they be abused, (3) how does Congress plan on stopping the danger or abuse, and (4) why does Warren Buffet disagree with Congress on this particular subject?

Teacher Phil said...

(1) How do you make big money in derivatives,

Biggest money is made by placing bets in credit default swaps before hiring people to stage events, i.e. taking down a company like Bear Stearns, blowing up a plane, collapsing a mortgage market.

(2) how are they dangerous or how can they be abused,

I've been wiped out twice on derivative trading. The outstanding value of all credit default swaps is 12 times the annual world GDP. At one point, there were 3x the value of GM bonds trading as credit default swaps before GM went bust. The abuse comes from bailouts. AIG provided insurance to almost everyone including some banks in Canada and Europe. The US government bailed out AIG, which enabled AIG to pay those credit default swaps even to Goldman Sachs and Canadian banks etc. No bailout, no payment. Theoretically, if the government printed 640 trillion dollars they could back every credit default swap.

(3) how does Congress plan on stopping the danger or abuse,

By requiring companies to hold about 10% of the maximum loss of the derivatives in cash. Now there is no requirement to hold any cash.

Jungle Jil said...

Once I've learned something, I like to try to summarize it into a short sentence that generalizes and simplifies, yet catches the overall idea of what I've learned. So tell me if this is pretty close to a good, simple explanation of derivatives:

Derivatives are a type of futures market... on anything that can be bought or sold. Unlike futures, however, you are not required to purchase the subject of the derivative at that time in the future should you choose not to.

Teacher Phil said...

That's a good definition of an option.

A derivative is any financial product/contract that has two counter parties. One party wins and the other party loses and equal amount. The amount of winning or losing is dependent (derived from) the amount of change in another financial product or event. Thus the security is called a derivative security.