Can someone explain financial derivatives to me?

[Darth Wong]

What the fuck are they? I keep hearing that there are $500 trillion of them out there. I know that they are basically unregulated. I know that Warren Buffett called them a "financial weapon of mass destruction" and worried that they could blow up the banking system. I know that Bernanke himself needed to meet with a number of banking experts in order to get up to speed on how they work.

So what the fuck are they?

[Master of Ossus]

What the fuck are they? I keep hearing that there are $500 trillion of them out there. I know that they are basically unregulated. I know that Warren Buffett called them a "financial weapon of mass destruction" and worried that they could blow up the banking system. I know that Bernanke himself needed to meet with a number of banking experts in order to get up to speed on how they work.

So what the fuck are they?

They're literally financial assets whose value is "derived" from some projected future value. They're used to hedge risk and, on the buyer's side, to leverage. The most basic ones (which you're probably familiar with) are futures and options (e.g., stock options).

I don't know how detailed you want me to be with this. They're "basically unregulated" in the sense that there are few large futures exchange markets, especially for non-commodity goods, so they largely have to be negotiated individually.

More interesting ones (to the financial community) include the "swap," in which companies who are each scheduled to receive cash flows in different currencies but of comparable projected value agree to trade off, so for example a US bank could hedge itself against currency fluctuations by trading an asset scheduled to pay them in Yen by "swapping" cash flows with a Japanese Bank (or other institution) which had a future cash flow denominated in dollars, since the US bank presumably has future liabilities in dollars and vice versa.

I think those are the basic financial derivatives.

[Admiral Valdemar]

As Ossus said, these are essentially contracts using various financial options and stocks with a pre-agreed value. The big problem is that, as the sub-prime and Bear Stearns events have shown, the assumed wealth traded is more a figment of peoples' imaginations because of the credit crisis.

All that traded hands via these markets may be worth next to nothing, just as mortgages and banks foreclose due to collapse in value.

[acesand8s]

As a basic definition, a derivative is a financial instrument that references a second, underlying instrument. For example, let's say you own a stock option on JP Morgan. This option, selling for $2, give you the right to buy a share of JP Morgan for $45 on or before April 18, 2008. JP Morgan is currently trading at about $42. By buying the option, you are effectively saying you believe the stock price will rise about $45 before April 18. Let's say that the price is $48 on April 3. You decide to exercise the option. You pay $45 dollars, get a share of JP Morgan, and can immediately turn around and sell the share for $48. Your profit is 48 - 45 - 2 = 1. The derivative on its own never had any intrinsic value. It's value was based solely on that of the JP Morgan stock.

There are four major forms of derivatives:

• Options - the right to buy/sell something at a set price by a set date
• Swaps - effectively an exchange of cash flows, one party pays return on one asset, the other party pays the return on a 2nd asset
• Forward - one party agrees to buy/sell an asset at a set price on a set date (different from an option in the fact that you must buy/sell)
• Futures - Similar to a forward, one party agrees to buy/sell an asset at a set price on a set date, but there is some regulation from the govt, there is more standardization, and the agreement is marked-to-market daily

These instruments were first developed by the business rather than investment community. Futures, for example, developed in Chicago in the early 19th century from farmers looking to secure the price of their wheat harvest. The farmer would approach a merchant, make an agreement to sell X bushels of wheat for Y dollars in Z days. If it was a bumper harvest and wheat prices fell, the farmer would be fine. If it was a poor harvest and prices were high, the farmer might lose money, but he'd at least have enough to live with. Farmers avoided the downside but lost some of the upside. In the mid-20th century, the financial/investment community became interested in these instruments as they realized they were a viable way to make money. So, in recent decades, the market for these derivatives has mushroomed as more and more capital has entered the space.

The danger from these instruments comes from leverage. A lot of these instruments are bought on margin; you effectively get a loan from the bank through which you buy the instrument. You can buy stock on margin, too, but stock margin requirements are set by the federal govt, and typically the NASD and the securities exchanges set the borrowing ability lower. In the case of derivatives, the margin requirements are set by the bank or clearinghouse. Typically you can get more margin with a derivative than with a stock. And once you borrow money to buy something, you can get wiped out very quickly. If you borrow 80% of the money to buy a futures contract, and the position falls by 20% over the course of the month, you have lost all your equity.

Now, the problem isn't one person getting wiped out. The problem is who they take down with them. This is the problem that occurred in 1998 with the hedge fund Long-Term Capital Management. LTCM had a ton of leverage when the bond markets blew up after the Russians defaulted. LTCM held a lot of risky positions and after Russia defaults, investors retreated into Treasuries and the value of LTCM's risky positions plummeted. News started leaking out that LTCM was in trouble, it was losing equity fast and would be forced to mass-liquidate its positions, which would cause prices of those securities to drop even more. Investors who thought they shared a position with LTCM, sold them immediately, not wanting to get caught in something sold off in a fire sale. Prices fell even faster, hurting LTCM more. After about a month, the Fed stepped in, got a coalition of investment banks to buy LTCM's entire book, all their holdings, at market value. Things calmed down somewhat at that point, as it became clear that LTCM wouldn't have to engage in a fire sale.

That is the concern with derivatives. You can become highly levered, which in a sustained down market can kill you. When you're forced into a fire sale, asset values fall well below what they are worth, resulting in major disruptions. The banks that create credit for normal, necessary daily transactions can get hit in the backlash. The problem with LTCM wasn't the fund failing, it was the fund failing and taking down with it all its counterparties, all the investment banks, which would have destroyed all the other financial transactions that those investment banks conduct.

[acesand8s]

One thing to note. Derivatives are a perfectly legitimate instrument for investment purposes. Many groups use them for their risk management aspects. Take, for example, the credit default swaps that were mentioned a few weeks back (they're protection against default from bond insurers). Some bond holders use them to protect their bond holdings, essentially they're buying insurance to reduce risk. Others use them for speculative purposes. A person might think company Z is going bankrupt, so they buy a credit default swap to get the insurance payout on the default. There is nothing wrong with that. The problem comes when you start using too much leverage to buy the CDS position and don't keep enough cash on hand to finance margin calls if the position goes against you (in either the long-run or the short-run).

In other words, issues only develop when people get greedy. And as any idiot could have told Wall Street, people always get greedy.

[Admiral Valdemar]

Would I be right in thinking there can also experience backwardation and contango like commodity futures too? A lot of furore over food and energy stocks is down to how the spot price compares with the future contract. Since you're leveraging a piece of the pie in a company, I presume market fluctuations can be just as bad depending on whether you go long or short.

Or is it a totally different ball game?

[acesand8s]

FYI, the backwardation/contango that AV refers to describes the relation between the futures price (what you would pay in the future) and the spot price (what you pay today) of an asset. Backwardation is a lower futures price than a spot price. Contango is the opposite, spot prices higher than futures.

Would I be right in thinking there can also experience backwardation and contango like commodity futures too? A lot of furore over food and energy stocks is down to how the spot price compares with the future contract. Since you're leveraging a piece of the pie in a company, I presume market fluctuations can be just as bad depending on whether you go long or short.

Or is it a totally different ball game?

I've only thought about backwardation and contango in relation to commodities (particularly oil), but it's possible. Part of the backwardation effect is the result of storage costs, which wouldn't be an issue with futures on things like stocks. But, the risks of having to commit to a future price on an asset are huge right now. So I imagine there must be some kind of discount being offered to the buyer of a future contract (in other words, backwardation or a lower future price than spot price). I've never dealt with equity futures, though.

[Admiral Valdemar]

Corrected your post issues.

Seems like it would still be quite a risky venture given the current climate anyway. When a company worth $150 a share last summer drops to $2 a share overnight, you can't really trust such valuations as much anymore.

I imagine that isn't helping with the "We must spend to grow" mantra coming out of Wall St./The City/Tokyo right now. If people lose confidence, then a massive cog in the machine just grinds to a halt. Now I can only picture a sort of Mexican stand-off going on amongst investors and their investments.

[Master of Ossus]

Corrected your post issues.

Seems like it would still be quite a risky venture given the current climate anyway. When a company worth $150 a share last summer drops to $2 a share overnight, you can't really trust such valuations as much anymore.

I imagine that isn't helping with the "We must spend to grow" mantra coming out of Wall St./The City/Tokyo right now. If people lose confidence, then a massive cog in the machine just grinds to a halt. Now I can only picture a sort of Mexican stand-off going on amongst investors and their investments.

Well, of course it's risky for the purchaser. I mean, these things can be worth nothing at all, depending on things that happen in the future. They're a way of distributing risk, but they can also be used to leverage the heck out of one's position. Amaranth, for instance, lost six BILLION dollars in assets in the space of a month because they massively over-relied on a single futures option.