Derivatives and their derivations

Many articles in this blog discusses various investment options, some more complicated than others. If you’ve achieved a level of success with your portfolio, you may be tempted to expand into more exotic that holds the potential of greater rewards.

What exactly are derivatives?

Derivatives are financial contracts whose value is derived (hence the name) from the value an underlying asset, like a stock, bond, or commodity. Instead of investing in the asset itself, the derivative contract will detail criteria, such as a stock price dropping past a certain level, that will trigger an event, such as an opportunity to exercise an option or a conversion.

Some examples of these contracts are:

Futures contracts – are available through regulated exchanges where the price for the underlying asset is set for a certain point in the future. These are usually used for commodities. Futures contracts have standard quality and quantity definitions that allow them to be traded on the exchange.

Forward contracts are the same as future contracts, except these are not done through an exchange, but rather is determined and agreed based on the parties involved.

Options are normally applied to stocks and will give the purchaser the right to buy (call) or sell (put) the underlying security for a specific price on a specific date. These are rights to exercise, not obligations, for the purchaser.

Swaps – are pretty much what they sound like. This is where two parties swap, or exchange, financial instruments. Typically, these revolve around interest rates, where one party will may pay a fixed interest rate to the other party on an amount while the other party pays the first party a varying rate on the same amount. This gets very complicated as to the whys and hows, and normally, retail investors are not involved in these transactions.

Remember the global economic downturn

You may recall that derivatives were what that brought the economy down in 2008 – most notably, mortgage-backed securities. These products bundled mortgages and based their values on the projected repayment. Unfortunately, these bundles, that allegedly received high ratings from credit agencies, contained many mortgages that were at extremely high risks of default. Which is what happened when the property bubble burst. And those mortgage-back securities plummeted in value.

That was a case where unscrupulous traders created questionable products that investors overlooked during boom times. It is, however, a cautionary tale that what may seem like a great idea still needs some research and due diligence.

Exotic and complex doesn’t mean better

But some of these instruments can sound as complex as gymnastics’ moves, and probably require equivalent mental agility to understand. Bloomberg wrote about a retiree who was convinced into purchase a reverse-convertible note with a knock-in put option tied to Merck stock. It was very likely that she was sold on the bond portion, with little explanation that these bonds converted to stock if the shares fell below a certain level, which it did, resulting in her losing much of her investment.

“Derivatives can be absolutely high-risk/high-reward propositions, or they can lower the risk when blended onto certain financial products” Richard emphasises. “You must have a very good understanding of financial instruments before you even consider venturing into derivatives. As with all my other advice, if you don’t fully understand the main drivers and triggers of an investment, you should avoid it or get more experienced advice.”