Overview
Derivatives are financial weapons of mass destruction (Buffett) or essential tools for risk management (Greenspan). They allow you to bet on the future price of something without owning it.
Core Idea
Hedging vs. Speculation:
- Hedging: Reducing risk. A farmer sells wheat futures to lock in a price before harvest.
- Speculation: Increasing risk. A trader buys wheat futures betting the price will go up.
Formal Definition (if applicable)
Call Option: The right (but not the obligation) to buy an asset at a specific price (Strike Price) by a specific date. Put Option: The right to sell an asset at a specific price.
Intuition
Insurance is a derivative. You pay a premium (price of the option). If your house burns down (stock crashes), the insurance pays out. If not, you lose the premium.
Examples
- Futures Contract: An agreement to buy/sell at a set date. (Unlike options, you must fulfill the contract).
- Swap: Exchanging cash flows (e.g., swapping a fixed interest rate for a variable one).
- The Big Short: Using Credit Default Swaps (CDS) to bet against the housing market.
Common Misconceptions
- “It’s gambling.” (It can be, but it serves a vital economic function of transferring risk to those willing to bear it.)
- “They are too complex to understand.” (The math is hard, but the concept is simple: betting on price movements.)
Related Concepts
- Leverage: Derivatives allow you to control a lot of value with a little money.
- Counterparty Risk: The risk that the other guy won’t pay.
- Black-Scholes Model: A Nobel-winning formula for pricing options.
Applications
- Airlines: Hedging fuel costs.
- Banks: Managing interest rate risk.
- Traders: Making money on volatility.
Criticism / Limitations
Complexity can hide risk. The 2008 crisis was amplified by derivatives (CDOs) that no one understood.
Further Reading
- Hull, Options, Futures, and Other Derivatives
- Lewis, The Big Short