Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Financial Derivative====== A Financial Derivative is a contract between two or more parties whose value is determined by, or //derived from//, the price of an [[underlying asset]]. Think of it less like owning a thing and more like making a formal agreement about the future price of that thing. The "thing" could be a [[stock]], a [[bond]], a commodity like gold or oil, an [[interest rate]], or even a market index like the [[S&P 500]]. Instead of buying a share of Apple, you could buy a derivative contract whose value goes up or down depending on what Apple's stock price does. This separation between the contract and the actual asset is what makes derivatives so powerful, flexible, and, for the unwary, incredibly dangerous. Their main uses are for [[hedging]] (reducing risk, like an insurance policy) and [[speculation]] (betting on future price movements). While professionals use them constantly, for most ordinary investors, they represent a level of complexity and risk that often outweighs their benefits. ===== What on Earth is a Derivative? ===== ==== The Core Idea: A Bet on the Future ==== At its heart, a derivative is a side-bet on the value of something else. Imagine a farmer who grows wheat and is worried the price will drop before harvest. At the same time, a baker is worried the price of wheat will rise, increasing their costs. They could sign a contract today agreeing on a fixed price for the farmer to sell, and the baker to buy, a certain amount of wheat in six months. This contract is a derivative. Its value doesn't come from the paper it's written on, but from how the actual market price of wheat changes over the next six months. If the wheat price plummets, the contract is very valuable to the farmer, who gets to sell at the higher, agreed-upon price. If the price soars, it's a lifesaver for the baker. They both used a derivative to hedge against future uncertainty. ===== The Main Flavors of Derivatives ===== While there are countless complex variations, most derivatives fall into one of four main categories. ==== Options: The Right, Not the Obligation ==== An [[options]] contract gives the buyer the **right**, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date. For this right, the buyer pays a fee called a [[premium]]. * **[[Call Option]]**: Gives you the right to **buy** an asset at a set price (the [[strike price]]). You’d buy a call if you think the asset's price is going to rise. * **[[Put Option]]**: Gives you the right to **sell** an asset at a set price. You’d buy a put if you think the asset's price is going to fall. Think of it like putting a non-refundable deposit on a house. You've paid for the //option// to buy the house at an agreed price, but if you change your mind, you can walk away, losing only your deposit (the premium). ==== Futures and Forwards: The Obligation to Transact ==== Unlike options, [[futures contract]]s and [[forward contract]]s are agreements that **oblige** you to buy or sell an asset at a future date for a predetermined price. The farmer and baker in our earlier example created a simple forward contract. The main difference is that futures are standardized and traded on public exchanges (like the Chicago Mercantile Exchange), making them transparent and liquid. Forwards are private, customizable agreements between two parties, known as [[over-the-counter]] (OTC) trades. This customization comes with higher [[counterparty risk]]—the risk that the other side of the deal will fail to pay up. ==== Swaps: Let's Trade Payments ==== A [[swaps]] contract is an agreement to exchange cash flows or financial instruments over a specified period. The most common type is an [[interest rate swap]]. For instance, a company with a variable-rate loan might worry about rising interest rates. They could "swap" their variable payment stream with another company that has a fixed-rate loan and prefers a variable rate. Each party agrees to pay the other's interest, effectively swapping their interest rate exposures without altering their original loans. ===== A Value Investor's Perspective on Derivatives ===== ==== Warren Buffett's Warning: "Financial Weapons of Mass Destruction" ==== Value investing's most famous proponent, [[Warren Buffett]], has a deep-seated skepticism of derivatives. He famously labeled them "financial weapons of mass destruction," pointing out that they can create a daisy chain of risk that threatens the entire financial system. His primary concerns are: * **Complexity**: Many derivative contracts are so complex that even the people creating and trading them may not fully understand all the embedded risks. * **[[Leverage]]**: Derivatives allow investors to control a large amount of an underlying asset with very little money down. This magnifies gains but, more importantly, it magnifies losses. It's easy to lose much more than your initial investment. * **Counterparty Risk**: Especially with OTC derivatives, the value of your contract depends on the other party staying solvent. In a crisis, as seen in 2008, one major default can trigger a catastrophic domino effect. ==== Can Derivatives Be Used for Value Investing? ==== Despite the warnings, some sophisticated investors use derivatives in a limited, defensive way that aligns with value principles. - **Selling Covered Calls**: If you own 100 shares of a company you believe is trading at or above its [[intrinsic value]], you could sell a call option against those shares. You receive the premium as instant income. If the stock price stays below the strike price, you keep the premium and your shares. If it rises above, your shares are "called away" (sold) at a price you were already happy with, plus you keep the premium. - **Buying Puts as Insurance**: An investor with a large, concentrated position might buy put options as a form of [[portfolio insurance]]. If the stock price falls dramatically, the gains on the put option would offset some of the losses on the stock, protecting against a catastrophe. ==== The Verdict for the Average Investor ==== **Proceed with extreme caution.** For the vast majority of ordinary investors, the path to wealth is paved with the direct ownership of wonderful businesses bought at sensible prices. While understanding derivatives is helpful for financial literacy, actively trading them invites a level of risk and complexity that is often unnecessary and unrewarded. The core of value investing is understanding what you own. With derivatives, what you "own" is a complex contract, not a piece of a business. That abstraction is where the danger lies. Stick to the businesses, not the bets.