Derivatives

I. Definition:

A derivative is a financial security with a value that is reliant upon, or

derived from, an underlying asset or group of assets. The derivative itself is
a contract between two or more parties, and its price is determined by
fluctuations in the underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market
indexes.

There are literally thousands of different types of financial derivatives.

However, most investment and financial engineering strategies revolve
around the following three:

1. Options
Options are contracts between two parties to buy or sell a
security at a given price. They are most often used to trade stock
options, but may be used for other investments as well. If an
investor purchases the right to buy an asset at a particular price
within a given time frame, he has purchased a call option.
Conversely, if he purchases the right to sell an asset at a given
price, he has purchased a put option.
2. Futures
Futures work on the same premise as options, although the
underlying security is different. Futures were traditionally used
for purchasing the rights to buy or sell a commodity, but they are
also used to purchase financial securities as well. It is possible to
purchase an S&P 500 index future, or a future associated with a
particular interest rate.
3. Swaps
Swaps give investors the opportunity to exchange the benefits of
their securities with each other. For example, one party may
have a bond with a fixed interest rate, but is in a line of business
where they have reason to prefer a varying interest rate. They
may enter into a swap contract with another party in order to
exchange interest rates.

II. Who Should Invest in Derivatives?

For the reasons listed above, this is a very tough market for novice
investors. Therefore, it is made up primarily of professional money
managers, financial engineers, and highly-experienced investors.

While any investor can no doubt dabble in derivatives to test things out,
beginners shoưuld not take high risks in this market given the potential
dangers. As you become more savvy and familiar with the various types of
derivatives and strategies that suit your investment style, you can start to
incorporate them further into your personal investment portfolio.

With that said, it is important to note that regardless of your experience

and knowledge, derivatives should only make up a portion of your
investment portfolio. Because they can be so volatile, relying heavily on
them could put you at serious financial risk.

III. Advantages of Derivatives

Derivatives are sound investment vehicles that make investing and

business practices more efficient and reliable.

Here are a few reasons why investing in derivatives is advantageous:

1. Non-Binding Contracts
When investors purchase a derivative on the open market, they
are purchasing the right to exercise it. However, they have no
obligation to actually exercise their option. As a result, this gives
them a lot of flexibility in executing their investment strategy.
That being said, some derivative classes (such as certain types of
swap agreements) are actually legally binding to investors, so it’s
very important to know what you’re getting into.
2. Leverage Returns
Derivatives give investors the ability to make extreme returns
that may not be possible with primary investment vehicles such
as stocks and bonds. When you invest in stock, it could take
seven years to double your money. With derivatives, it is
possible to double your money in a week, however it is also
harmful that will be mentioned later
3. Advanced Investment Strategies
Financial engineering is an entire field based off of derivatives.
 They make it possible to create complex investment strategies
that investors can use to their advantage.

IV. Potential Pitfalls

The concept of derivatives is a good one. However, irresponsible use by

those in the financial industry can put investors in danger. Famed investor
Warren Buffet actually referred to them as “instruments of mass
destruction” (although he also feels many securities are mislabeled as
derivatives).

Investors considering derivatives should be wary of the following:

1. Volatile Investments
Most derivatives are traded on the open market. This is
problematic for investors, because the security fluctuates in
value. It is constantly changing hands and the party who created
the derivative has no control over who owns it. In a private
contract, each party can negotiate the terms depending on the
other party’s position. When a derivative is sold on the open
market, large positions may be purchased by investors who have
a high likelihood to default on their investment. The other party
can’t change the terms to respond to the additional risk, because
they are transferred to the owner of the new derivative. Due to
this volatility, it is possible for them to lose their entire value
overnight.
2. Overpriced Options
Derivatives are also very difficult to value because they are
based off other securities. Since it’s already difficult to price the
value of a share of stock, it becomes that much more difficult to
accurately price a derivative based on that stock. Moreover,
because the derivatives market is not as liquid as the stock
market, and there aren’t as many “players” in the market to close
them,  there are much larger bid-ask spreads.
3. Time Restrictions
Possibly the biggest reason derivatives are risky for investors is
that they have a specified contract life. After they expire, they
become worthless. If your investment bet doesn’t work out
 within the specified time frame, you will be faced with a 100%
loss.
4. Potential for Scams
Many people have a hard time understanding derivatives. Scam
artists often use derivatives to build complex schemes to take
advantage of both amateur and professional investors.
The Bernie Madoff ponzi scheme is a good example of this.
V. Derivatives Summary
Derivatives are a security that derive their value from an underlying asset
or benchmark. Common derivatives include futures contracts, options and
swaps. Most derivatives are not traded on exchanges and are used by
institutions to hedge risk or speculate on price changes in the underlying
asset. Exchange-traded derivatives like futures and stock options are
standardized and eliminate or reduce many of the risks of over-the-counter
derivatives like counterparty and liquidityrisks. Derivatives are usually
leveraged instruments, which increases the potential risks and rewards of
these securities.