Oh no here come the financial concepts, time to clear the cob webs we are going to talk about derivatives. Want to sound smart at work today, drop the word derivative in some random sentences and wait for the looks you get.
This is how my wife fell in love with me. Except this was back in college and I was a Chemistry major at the time. I started dropping some names of the elements off the periodic table and the rest is history.
What is a derivative?
What does the word mean, let’s take the root, derive. Derive means to have origins in something else. The lakes name was derived from ancient Mayan mythology. With that said the derivative in the financial market is a security whose underlying asset determines the price. Fluctuations in the value of the underlying asset (stock, bonds, currencies, market indexes) determine the price of the derivative. You are betting whether you believe the price of the underlying asset will increase in price or decrease in price by a certain amount over a certain period of time. Generally speaking, a derivative is often very risky; if you are risk adverse you may want to proceed with caution.
Why derivatives and how are derivatives used?
The question is why not, they are used for speculative purposes; remember the name of the game is managing risk. Remember the other day when you were reading my article about Beta? Alright go take a look, I will wait for you! We are using the derivatives as a hedging maneuver to reduce the risk of our portfolio.
Types of Derivatives
The list is quite long for the list of derivatives; I could go on for weeks explaining all of these. Common types of derivative contracts are: forwards, futures, options, warrants, swaps which then is broken out into interest rate and currency swap. The title of the article is one of the varieties of the options.
Example of Derivatives
If you are still following along let’s take a look at an example: British company buying shares of (TTaTM) This That and The MBA off the NYSE using a stack of Benjamin Franklin’s! This company is exposed to fluctuations in exchange rates between the nations. To try to minimize the impact (hedge) of these flucations the British company would purchase currency futures. This is a maneuver to lock in a particular exchange rate for any potential sale of the underlying stock of TTaTM, and the currency conversion back into Euros, the currency to which the British company prepares its financial statements. That scenario we minimized the currency exchange rate fluctuations, if the British company wanted to invest in my company without the options contract they would be exposed to the volatility of my stock along with the volatility of the exchange rates.
Any questions class? What do you think? I know we are Personal Finance bloggers, but has anyone had the privilege of working with options contracts? Care to share a story or two?