Sunday, June 13, 2010

Derivatives serve a purpose, when used correctly

Published in The Tennessean, Sunday, June 13, 2010

Derivatives serve a purpose, when used correctly

by Richard J. Grant

Readers ask about derivatives. These include forward contracts, futures, options, and swaps. A derivative is a financial security whose value derives from the value of something else that we call the "underlying." The underlying might be a commodity price, an interest rate, a stock price, an exchange rate, or even another derivative.

Suppose you buy an ounce of gold for $1000. If the gold price then rises to $1100, you could sell it for a $100 profit, a gain of 10 percent. But if the price had fallen to $900, you would have lost 10 percent.

Now suppose that you have only $100 but can borrow $900 to buy the ounce of gold. If the price then rises to $1100, you would once again make a profit of $100. This time your capital gain is 100 percent. But a price fall to $900 would wipe out your initial capital. If it falls further, you lose more than 100 percent. By combining asset ownership with debt, you have created leverage. The net value of your capital is far more volatile than it would have been.

Futures: Rather than borrow, you could enter into an agreement today to buy an ounce of gold for $1000 six months from today. If you put down a $100 deposit, then you are in a risk situation similar to that of the loan example. This is known as a forward or futures contract.

Options: If you wanted to limit your downside risk, you could pay someone a premium, say $10, for the option to buy an ounce of gold for $1000 within the next six months. You would have the right but not the obligation to buy. If the gold price rises to $1100, then you could exercise your option (buy for $1000, sell for $1100) and get a profit of $90 ($100 minus $10). But if the gold price does not rise above $1000 during that time, then the option will expire worthless and you will have lost your $10.

Swaps: Swaps are agreements to exchange cash flows during a specified period of time. For example, if you are obligated to make payments according to a variable interest rate, but would prefer to make fixed interest payments, then you could contract with someone who is in the opposite situation to swap payment obligations (according to a formula).

In each of these examples, you could have been in the opposite situation: you could sell (go short) rather than buy (go long). This makes derivatives very useful tools for hedging our risks. They enable us to reduce the total effects of the natural risk in our lives by contracting with people who are better able to evaluate and bear those risks.

Most derivatives are not difficult to understand. But, as in any type of agreement or relationship, they can be made to be very complex. Even plain gold bullion has a complex multitude of influences on its value. Using debt (borrowing) or derivatives in your portfolio, adds leverage and increases the potential volatility of your portfolio's net value. You need to understand those effects and how to balance, monitor, and control them through time.

The demonization of derivatives in general is a sign of confusion, a fear born of ignorance. Derivatives cause harm only when misused. But that charge can also be leveled against the use of debt, cars, lawnmowers, and baseball bats. Mama taught us not to run with scissors; we can learn to use derivatives safely also.

Those who do not study derivatives should not use (or regulate) them. Most people don't. But many people get into debt carelessly; and in so doing, they put their homes and other assets at risk.

From a national perspective, government should not bail out those individuals or institutions that misuse debt and derivatives. Markets protect us by moving capital away from the imprudent. Bailouts reward and encourage recklessness.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010