posted on Dec, 13 2010 @ 04:46 PM
As some have pointed out in this thread, financial derivatives are like instruments of gambling. They are a subset of "financial instruments". The
principles of derivatives are the same as gambling: the dealer tries to set up a game that he/she does not lose and make sure the game attracts
various parties to play. These parties can be individuals, institutions and even national governments.
However, using the word "gambling" to define financial derivatives is an over-generalization. To understand derivatives, you have to go a bit
further. Gambling is all about risk acceptance. To someone very risk-averse, a success probability of 90% can still be a "gamble". To someone
risk-taking, a success probabillity of 30% can be a sure thing. Gambling or not, it is not in the absolute but the extent. Therefore, anything can be
a gamble. To risk-takers, "Life is a gamble".
In fact, many types of deravitives can be viewed as tradable insurance policies. Imagine that you can resell your health insurance with your
endorsement on a secondary market, should the insurance companies allow! Those who issue (or create) derivatives have a mindset similar to insurance
companies. They attract you to buy the insurances by appealing to your fear and greed. In insurance industry, they talk about "coverage" (What if
you die tomorrow from an accident?), while in derivatives, they emphasize "hedging" (What if a country default on its debt obligations? CDS). You
jump in because you want the coverage or the hedge, and you think it is necessary and can be achieved. Its all about your perceptions. Coverage and
hedging are both marketing jargons for risk-averse parties. To attract risk-takers, derivatives issuers (underwriters) play on the "hope" of
speculation (read: bet). No matter which culture you are in, there are always individuals or groups who have the dream to "win" wealth not by
working but by betting. You know it. Greedy people are everywhere. You can't live without them!
Some derivatives are pure bets, such as index options. Some has connection to real assets through delivery of "underlying assets", such as commodity
futures and stock options. The connection to "reality" lies in the fact that, if you wait until the maturity of these derivatives, you would have to
"go under" and deliver the promised assets, be it commodities or stocks. Consider these "deliverable" derivatives as gambling that involves your
own assets or even your wife!! What if you lose, you'd have to give away your spouse because of the agreement you signed?? ;-)
Why do banks wish to recruit physics graduate for their derivatives business? Because they are usually the underwriters of derivatives. To make it
simpler, they sell insurance policies. Insurance companies operate on econometrics. They must make sure that their gains from insurance premiums far
outweigh their loss on insurance claims. This is mostly based on the calculation of probabilities and statistics: how many people are usually sick
amongst the whole population? What are the likelihood of death of a certain age group? To be accurate on your estimate, you'll need serious
statistics and mathematical models. In options, it is called the "underwriter's strategy". I have only used the examples of life and health
insurance. What if the derivatives involve the likelihood of default of a country? What if it involves weather (weather derivatives)? It can be much
more fluid and complex than common insurances.
For those buying the derivatives (banks as the major players again), they also need to understand the contraints and probabilities. Graduates with
mathematical backgrounds are favored for the econometrics tasks as well. The difference for speculators is that you will not be able to replicate the
model of underwriters totally, but you still need to make your modelling as accurate as possible.
Yes, there are sophisticated softwares to model the complexities. Yet the softwares are based on mathematical models, which in turn are based on
correct understanding of environmental variables. Because the environments are not totally understood and they change from time to time, you need to
keep adapting your models and keep them as accurate as possible. Who are the most capable of such modelling tasks? Those who have a strong
mathematical and logical background. Physics majors are one of the kind. Graduates of econometrics and applied mathematics are good candidates, too.
Coming back to the similarity between insurance and derivatives, we can all see the reality here: Insurances are necessary. For some members of a
population to be willing to take risks (for the advancement of the group), the potential loss from failure should be spread among the whole
population. The question is: how many insurance do we need and how much insurance can a society sustain?? Nothing can grow forever and everything has
a cost. The same goes for derivatives. The current problem is that derivatives are out of control. Bankers to blame, definitely. But individuals who
surrender to their greed and fear are responsible, too.
All in all, what is the underpinning premise of derivatives? Easy! It is ownership. If you cannot own anything, what is use of gambling, even if you
like it so much? Some gamblers in some countries are even willing to give away their house or spouse when they are desperate, because of what? Because
they consider themselves "owners" of their propoerty and spouse. It is all because of ownership, the source of evil of capitalism.