by Stephanie Miles

What are Derivatives Really?

What are financial derivatives? A

If you’ve dabbled in the markets or tried your hand at investing in recent years, you’ve most likely heard the term “derivative” tossed around. Maybe you’ve heard money managers use the word to describe options based on assets such as stocks, while financial publications dive into the use of credit default swaps when writing about the 2008 financial crisis. The rest of us, however, are often left on the outside of these conversations, not quite sure what derivatives are or how they might affect us.

What are financial derivatives?

Financial derivatives are used for two main purposes to speculate and to hedge investments. Let’s look at a hedging example. Since the weather is difficult–if not impossible–to predict, orange growers in Florida rely on derivatives to hedge their exposure to bad weather that could destroy an entire season’s crop. Think of it as an insurance policy—farmers purchase derivatives that allow them to benefit if the weather damages or destroys their crop. If the weather is good, and the result is a bumper crop, then the farmer is only out the cost of purchasing the derivative.

Part of the reason why many find it hard to understand derivatives is that the term itself refers to a wide variety of financial instruments. At its most basic, a financial derivative is a contract between two parties that specifies conditions under which payments are made between two parties. Derivatives are “derived” from underlying assets such as stocks, contracts, swaps, or even, as we now know, measurable events such as weather. Conditions that determine when payments are made often include the price of the underlying asset and the date at which the underlying asset achieves that price.

Let’s look at a common derivative–a call option–in more detail. A call option gives the buyer of the option the right, but not the obligation, to purchase an agreed quantity of stock at a certain price on a certain date. The price is known as the “strike price” and the date is known as the “expiration date”. Let’s say I purchase an option for $2.17 to buy IBM stock at a strike price of $190 and an expiration date in one month’s time (as of today, that’s August 17, 2012). I will only exercise that option to purchase the stock on that date if the price of IBM is greater than $192.17–the cost of purchasing the option plus the cost of purchasing the stock. If the stock price rises to $200 before August 17, 2012, then I’ll exercise my option and pocket $7.83–the difference between $200 and $192.17. Now, it’s much easier said than done. Call options are speculative, risky investments. You can often be right on the direction that the stock price moves, but wrong on timing. It can be a very painful lesson to learn.

Why all the controversy?

Not everyone is a fan of using derivatives, including investors as regarded as Warren Buffett. In a 2002 letter to Berkshire Hathaway shareholders (PDF), Buffett describes derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Buffett has largely been proven correct in the time since his initial statement, now that experts widely blame derivative instruments like collateralized debt obligations (CDOs) and credit default swaps (CDSs) for the financial crisis in 2008. In his 2012 paper, Derivative Instruments and the Financial Crisis 2007-2008: Role and Responsibility, Swiss Management Center University Professor Joe Sammut argues that “business in CDOs would not have been so gargantuan had their purchasers not have been able to hedge their positions through CDSs.” Despite their potential danger, derivatives can take many forms and as a result it can be difficult for regulators to maintain oversight to the market for derivatives.

Are derivatives inherently evil?

Despite the role that derivatives played in the 2008 financial crisis, derivatives aren’t inherently bad. Even Buffett has pulled back on his previous statements, telling the Financial Crisis Inquiry Commission in 2011, “I don’t think they’re evil per se…there’s nothing wrong with having a futures contract or something of the sort.” According to the New York Times, Buffett now says the real problem with derivates has to do with overexposure by the banks and “uninformed investors.” He believes derivatives can add value to companies, including Berkshire Hathaway, as long as leaders at those companies use restraint and hold a “limited amount.”

Derivatives may not be a financial instrument that the average investor wants to try on her own, but derivatives can add value to society when used appropriately and in moderation. Regardless, it’s useful to understand them, and know their risks and benefits. Ask an orange farmer in Florida.