Basics of derivatives
Need to buy these? Hedge your cost w/derivatives.
The big news in Washington this week is the financial overhaul bill attempting to be debated in the Senate. Many Republicans still oppose some items of the bill, but a majority of the public and politicians are in favor of additional controls in the financial markets one way or another; the difficulty is in balancing control without abusing government power.
Controlling derivatives is the biggest talking point of the overhaul, so it would help to know a little about derivatives before getting into a conversation.
“Derivatives are private contracts that allow traders to bet on the direction of the prices of stocks, commodities and other assets. Many companies also use such deals to lock in prices for goods, such as oil, which often fluctuate in value.”1
Think of it as betting on the future price of something. Derivatives are often used by large companies to hedge costs, but even individuals or small companies can benefit by protecting themselves.
Simple example: a local home builder makes his money from the difference in a home’s sale price to the total cost and labor put into the house. If the cost of materials greatly increases, his profit will decrease. Therefore, buying futures in materials like copper would help offset decreasing profit margins thanks to income from a successful bet on rising copper prices. Naturally, low prices help the profit margin but will mean losses on your derivatives bets, so they should be treated as an insurance or allocated as such.
Derivatives aren’t just for hedging, though. Speculators who simply want to bet on the future price of something can make or lose money in a hurry. The financial overhaul bill is trying to make all of these trades public and transparent so the market stays true to supply and demand nature without banks taking on any more unnecessary risk.
Everything from oil to currency to exchange rates to credit to orange juice can be traded as derivatives. There is a lot more to be learned about the confusing derivatives market, but at least now you’ve got a foothold on the subject.
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