Guest Contributor: Phil Sindel, Executive Director, Olmstead Associates, Inc.
Say the word derivatives to some people and watch them begin to sweat, shake and think about widows and orphans being thrown out on the street. Derivatives appear to have pretty bad public relations! They have been blamed for everything from the current financial crisis to the high price of gasoline to bad weather. What contributes to this is not just what derivatives are but also how they are used.
First, a simple definition. A derivative is a security that derives its value from an underlying security or asset. Stock options derive their value from the value of the underlying stock. Despite their reputation, a primary use of derivatives is not to increase a portfolio’s risk but to decrease it. Used as a hedge, derivatives such as future contracts can help the farmers protect against fluctuations in the price of their crops and portfolio managers guard against unwelcome changes in interest rates.
However, the same derivatives that can be used as a hedge can also be used to make a bet (i.e speculate). Make a bet whether interest rates are going up or down, make a bet as to whether the price of a commodity is going up and down. And, as with all bets, there can be only two outcomes, either you bet right and win the bet or you bet wrong and lose the bet. Referred to in mathematics as a zero sum game.
The final piece to the puzzle is the fact that derivatives can be a highly leveraged investment. In other words, it doesn’t take a lot to control a lot. A $100,000 derivative might only require a $10,000 investment. Should the derivative increase in value by just 10% (i.e. $10,000), we realize a return of 100% on our actual investment! However, a decrease in value of just 10% wipes us out.
Therefore, when derivatives are used as a speculative investment done in a highly leveraged manner, many contend that is a recipe for disaster. The contention is not only are you making a bet but you are doing it with borrowed money. And, of course, when these investments go bad, they tend to be excellent fodder for the press.
The answer some say is to get rid of the speculators and force investors to deleverage. Reality is always a lot more complicated. In order for the hedgers to be able to continue to use derivatives to protect their portfolios against risk, the market needs the participation of the speculators to provide liquidity. And to maximize the ability for investors to participate, leverage can be a formidable tool to allow that to happen.
So is the derivative an investment that can protect us against risk and deserves a better reputation? Or is the financial equivalent of the devil and will the world to brink of destruction? As you can see the answer is a solid maybe!
*For further explanation on how derivatives work, check out our Understanding Derivatives & Other Complex Securities training course taught by Phil Sindel.