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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.

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