THE GOOD

THE BAD

THE UGLY

PROFIT AHEAD

Derivatives are financial instruments whose value is derived

from an underlying asset (stocks, bonds, commodities, etc.). Traders

can swap interest rates, take bets on whether a firm will go bankrupt,

safeguard against future asset price increases, etc—all under the

umbrella term derivative.

It’s not the concept of derivatives themselves that is the problem – it’s the

sloppy way they’ve been used.

Derivatives are generally used to transform one kind of risk into another, so

for example a farmer might sell a futures contract obligating him to deliver

a certain amount of wheat of a certain quality in future time.

Derivatives can be used to swap interest rate risk for equity (stock market)

risk, or to reduce or increase exposure to the price of a share or index rising

or falling.

Example-

LTCM hedge fund generated 43% and 41% returns in first two years of it’s

operation.

Derivative are traded over the counter, as an individual contract between t

wo parties. This means that there is no central pricing authority that sets a

valuation for these things.

In OTC derivatives, counterparties rely on individual agreements about

margining, and firm make their own assessments about the creditworthiness

of their trading partners. In practice this means that large derivatives

positions can be built up without putting up large amounts of money (lever

age, anyone?), and counterparty risk can be very significant over time.

Example- Allied Irish Bank incurred $691 million losses due to inefficient

management and its currency arbitrage trading strategy.

Can be very hard to value, because they may be based on underlying

securities that are themselves hard to price, or hardly ever trade.

Banks and brokerages may not have a full understanding of the market

risk in their derivative positions, let alone the counterparty risk.

Example-

Mortgage-backed securities, another type of derivative, were blamed for

creating the housing bubble and subsequent recession.

Barings Bank, one of the world’s oldest merchant banks went bankrupt by

incurring losses approximately $1.25 billion.

And THAT’s whyderivatives might one day come to

your door in the middle of the nightand suck your soul out through your

eyeballs. Don’t say I didn’t warnyou.