Derivatives: The most Basic of Basic Introductions
Many people are talking about the Stock Market. But hardly anyone is talking about Derivatives. Strange – because size for size the Stock Market is the size of a mouse and Derivatives are the size of an elephant.
What are derivatives?
A derivative is a financial instrument – or more simply, an agreement between two people or two parties – that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to – such as a share, or a currency.
A derivative is basically a bet. Yes, the stock market is a bet, but at least when you buy stock you own part of a company that provides goods or services, so it usually has some intrinsic value. Referring to derivatives as stand-alone assets would be a misconception, since a derivative is incapable of having value of its own. When you own a derivative, you own nothing. However, some more commonplace derivatives, such as swaps, futures, and options, have been traded on markets before their expiration date as if they were assets.
Derivatives includes such things as options and futures, but there are all kinds of derivatives available now – including bets on interest rates and even on the weather!!! The size of the derivatives market has become important in the last 15 years or so. In Feb 2009 the total world derivatives market expanded to $1,000 trillion!!!! Note that there are SIX times the amount of derivatives as the total world GDP. It’s a bit hard to imagine.
Credit Derivatives
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. Stated in plain language, a credit derivative is a wager, and the reference entity is the thing being wagered on. Similar to placing a bet at the racetrack, where the person placing the bet does not own the horse or the track or have anything else to do with the race, the person buying the credit derivative doesn’t necessarily own the bond (the reference entity) that is the object of the wager. He or she simply believes that there is a good chance that the bond or collateralized debt obligation (CDO) in question will default (go to zero value). Originally conceived as a kind of insurance policy for owners of bonds or CDO’s, it evolved into a freestanding investment strategy. If the buyer of the derivative believes the underlying bond will go bust within a year (usually an extremely unlikely event) the buyer stands to reap a 100 fold profit. A small handful of investors anticipated the credit crunch of 2007/8 and made billions placing “bets” via this method. Risks involving credit derivatives are a concern among regulators of financial markets. The challenge, when it comes to Credit Derivatives, is regulating them and other derivatives.The people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. After the financial crisis, many people have argued that these financial instruments require stricter regulations.
Like all other things, derivatives have a good and a bad side. After the recent financial crisis, people have spoke a lot about the negative side to these objects of financial innovation. In our next article, we will look at why these instruments were created to get a closer look into their benefits. We will also look at how they caused or helped the market on its way down.
References
[1] http://en.wikipedia.org/wiki/Derivative_%28finance%29
[2] http://blogs.hbr.org/finance-the-way-forward/
[3] http://www.portfolio.com/views/columns/wall-street/2008/10/15/Credit-Derivatives-Role-in-Crash/
Computational Economics 
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