Three ways to think of derivatives

The topic of "derivatives" is a complex one, and usually explained poorly because it can quickly get technical. Yesterday I tried to write as simple a guide to derivatives for the non-specialist and failed completely: I had written three times as much as I intended and the concept still wasn't clear.

Instead of trying to do that, I'm just going to toss out three different ways to think about what derivatives actually are. Hopefully for some of the perplexed out there, they can mull these ideas over and apply them to other reading to get a better idea of what derivatives are and what they imply.

1.A derivative is a contaract between parties. When you buy a stock, you are buying a piece of a company. When you buy a house, you are buying a building. When you enter into a derivatives contract, you make an agreement with another party to do something.

2. Derivatives can serve as a form of insurance. If you are worried that something might or might not happen, you can take out a derivative to help you cover possible losses, exactly the same way a homeowner can take out insurance against fire, theft, whatever. The only difference with derivatives is that in addition to being used this way sensibly, they can be used nonsensically. For example, it is possible to create derivatives that "insure" against events that have nothing whatsoever to do with you. An analogy would be that instead of taking out insurance on your own car, you look at some weaving drunk driver and say "That guy is a terrible driver. I want to to take out some insurance that lets me pay a tiny bit now and delivers me a big payout when he finally crashes." Derivatives essentially allow this.,

3. Derivatives can serve as a kind of gambling. Following the last sentence of the above, you can see how easily this system can be turned into what is essentially raw gambling. It allows company A to bet on whether company B (which may be totally unrelated to them) will experience this or that condition. It allows betting on practically anything, from weather patterns to election outcomes. Companies can try to rationalize this by saying, "Well, these factors have potential impact on our business interests so we want insurnace against such-and-such." but in so many cases the system was abused so crassly and in ways that people are only beginning to grasp now. For example, there are even derivatives on derivatives, or derivatives that provide payouts (or extract cash) based on what happens with other derivatives.

There has been a lot of confusion about what exactly "derivatives" are and how they function. Even though I have been studying derivatives markets since 2003 or so, many of the aspects of this kind of finace remain a mistery to me. It is my hope, however, that the three above points will allow non-finance types to get some sort of a handle on the nature of derivatives, and can use this to supplement further reading.



[edit on 9/27/09 by silent thunder]

"Derivatives are financial weapons of mass destruction". Warren Buffet.

If an investment becomes so complex you yourself can not understand then you stay far far away from it.

Hey silent thunder,
Good job! I'm not an expert at all on this topic but I've tried to educate myself and even when I feel like I get it I find it hard to explain.
In essence, it is gambling. The whole of the market is gambling but derivatives push it to the vegas bookie level.
At the very least, you've created a very good starting point for discussion.