Financial Weapons of Mass Destruction: A Look At How Derivatives Work

Warren Buffett has once officially declared derivatives as “financial weapons of mass destruction”.

Derivatives? Oh no, I am not talking about high school calculus.

The Basics

A financial derivative that is a security that “derives” its value from another item or value. The most traditional derivatives are stock options, futures, forwards and swaps. However derivatives come in all shapes and sizes, and most recently we have seen something like Collateralized Debt Obligations or CDOs in the US and European markets.

CDOs were popular with bankers in the 2000’s, however they did not understand the risk associated with the instruments and losses can mount up as high as St.Agnes. CDOs are essentially any loans with a bundle of assets attached to them, which in the 2007 market debacle, were mortgages on houses.  The loan and the asset are usually grouped together and sold as a single instrument.

Traditional derivatives are more tried and true, hence they are more reliable to certain extent.

Options give owners the right to buy something at a certain value at a certain point in time.

Futures and forwards give investors the right to buy something at a certain value at a later date. A grape farmer can sell next year’s harvest by visiting the futures or forwards markets to someone who is willing to buy at a price set in advance (a counterparty). Terms for futures are standardized, unlike forwards. Future contracts correspond to other contracts, hence they can be traded on exchanges globally.

Finally, a swap is essentially prearranged financial operations that exchanges one series of income flow for another, that matches the trading institution’s funding and risk requirements.

The original idea of derivatives is great. It is to reduce risk for one party, while offering another party the potential for a high return because they are willing to take on that risk. One party wants to reduce risk, and another party who is willing to take the risk is rewarded for doing so, sounds like a match made in Heaven.

For example, I am selling a derivative based on the S&P 500 index, and I’m expecting the index to move in a particular direction. If I think the index will rise, I will sell a future on the index. This will allow a buyer to lock in a fixed return (reducing risk for the buyer), and I’m trying to make a gain (while assuming the risk by selling at a fixed price, because I will be at a disadvantage if the index does not rise).

Derivatives are risky. Why? Derivatives can rise or fall sharply based on how the underlying item changes in value. Portolios rise or fall in the turbulent market as currencies and interest rates rising rapidly during these market changes.

What is the best example? 2007 global housing market collapse. Many debt derived from subprime loans were sold, and home buyers default a lot of these derivative products become worthless. Banks and insurance companies around the globe suffered greatly.

Another example would be the ever infamous Enron, which went bankrupt while speculating on derivatives based on energy prices.

Where there is greed, there is a way, there is an investment product. Derivatives have based its value on a more diverse base of underlying assets than ever. There are derivatives which absurdly trade based on underlying assets such as consumer price index and weather conditions.  Hedging even occurs in sports betting, and websites are offering hedges and options based on sports scores.

With the rise of of the booming economy of the Red Dragon China, freight derivatives have become increasingly popular. These are forward contracts that allow shipowners and manufacturers to lock in a fee for renting a ship. This has greatly aided the shipping of goods from one part of the globe to another. China’s heavy reliance on cargo ships to send exports to foreign markets and bring in raw materials from abroad greatly encourages the trade of freight derivatives.

So if the stock market goes up or down over a given period of time, who is to determine what’s the worth of a derivative?

In fact, many investors refuse to trade with derivatives. Mr.Buffett calls them the “financial weapons of mass destruction”. In some countries, certain governments have called for greater control of derivative trading. Apparently governments and the ultimate investment guru see the potential for unexpected derivative losses leading to an economic crisis, which is very likely in our very well connected global trade market.

Derivatives were meant to reduce risk, not increase it. If used properly as intended, these instruments should allow companies to spread risk and facilitate trade. However, they have caused more problems for many companies.

Isn’t it ironic……don’t you think?

 

 

Q

 

Reference: The 21st Century Economy – by Randy Charles Epping

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