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Few viewers knew what these amusing investments were; about 25 years later, the term ‘derivatives’ was seared on our hearts.
Derivatives were investments heavily involved in the economic meltdown that hit us all five or six years ago, and one reason they gained such scary power is because they can be extremely complex and difficult even for the very experienced trader to understand.
A derivative has no value in and of itself: it derives its
value from an underlying thing, like a commodity or asset, an index or an
interest rate. Many of them are rather simple, actually.
Take wheat futures: a
farmer wants to grow a crop of wheat. He knows that the possibility exists that
the price of wheat (a commodity) could drop precipitously just as he’s ready to
bring his crop to market. So he buys insurance against that possibility – an
insurance policy that derives its value from the underlying crop.
This means that the financial company selling him the policy is the one taking the financial risk. Now he can plant with some peace of mind.
This is a prudent and healthy way to use derivatives, a kind
of risk management which helps the farmer and offers the financial company an
opportunity to make some money.
However, derivatives can also be used as an
instrument for speculation.
Investors can take a chance on the underlying value
(let’s say of a stock): they essentially bet against the holder of the stock
about how high the share price will rise. If they get it wrong, they’ll lose
badly, but if they get it right, they are winners (a term well-used here: this
is essentially not much different from gambling).
When that’s the case, it’s entirely possible for the risk-taking to get out of hand (which is what was happening when the bottom fell out of our world).
There has to be a balance between the asset or other entity
from which the derivative gets its value. Think about this: the total value of
goods and services produced around the world is somewhere in the region of $70trn; the total value of our financial assets as a planet is just over
twice that.
The total value of the derivatives in the world is about $700trn – ten times the full value of our goods and services. If things go wrong – as happened with the mortgage sub-prime crisis – we are poised on a knife-edge. The prudent investment expert will plan for the unexpected crisis by pricing in things like a potential surge in the price of oil.
Derivatives are not for beginners: seek the advice of an expert, someone who has extensive experience with this kind of investment.
- Fin24
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