September 2009 Market Update (2) – What Are Derivatives?

As a result of my previous market commentary, pointing out the dangers of derivative trading to the general market, I have had several requests to define financial derivatives more fully.

I will do my best, but remember, some derivatives are extremely complex in nature. A derivative is a financial instrument whose value is derived from the price of another financial instrument. It can be based on the price of a commodity such as oil or wheat, a security such as a stock or a bond, an index of securities or a currency. It’s a promise to convey ownership of the asset on which it’s based and doesn’t represent ownership of the asset itself. When you buy a derivative, you’re betting on how the financial instrument or underlying asset will perform. They can help hedge against specific risks involved in owning the underlying asset but are also used as speculative investments themselves. Institutional investors such as hedge funds, pension funds and managers of mutual funds may use them as part of investing strategies. The risks involved depends on the type of derivative but may include interest rate risk, market risk, liquidity risk, prepayment risk and currency risk.In many cases, derivatives are leveraged and are not suitable for all investors.

There are dozens of types of derivatives. Let me describe just one; credit default swaps. Let me give you a hypothetical example:

Sam Slick, manager of a hedge fund, wants to improve the performance numbers of his fund. He calls his friendly broker who puts him in touch with a derivative trader at XYZ Company. They negotiate a type of derivative contract on $1,000,000 of Acme bonds that stipulates that if Acme should default on its bonds, then the insurer, XYZ Company, will pay $1,000,000 to Sam Slick’s hedge fund even though the hedge fund does not actually own any Acme bonds. For this “insurance” Sam pays XYZ Company a premium of $5000 and XYZ Company does NOT need to have $1,000,000 in reserve to pay off this bet as it is an unregulated derivative.

If Acme goes under, Sam gets an extra million for his hedge fund having taken little risk.

If Acme does not fail, XYZ Company has made a profit on the premium and the broker makes a trading commission. BUT, if Acme fails, XYZ Company has to come up with $1,000,000 to pay the contract.

Where will XYZ Company get the money since it does not have to keep the money in reserves? It will come from XYZ Company’s own portfolio holdings, which it has to have in reserve to back its insurance liabilities. If it doesn’t happen to have $1,000,000 in cash then it must liquidate some of its positions in perfectly good stocks and bonds to pay the debt.

We could be talking about trillions of dollars (685 trillion over the entire derivative market) of these contracts that may potentially be triggered to pay off on any given day if a particular bond defaults.

Where do the trillions of dollars come from to make the payments? They come from selling the same stocks and bonds that you have in your portfolio or your mutual funds, thereby driving down the value of your holdings. Your holdings are still excellent companies, but it doesn’t matter if their shares have to be liquidated to make good on these derivative contracts.

This is one contributing factor as to why the market has become so volatile and unstable. In my opinion, this is why it is fruitless to try to structure a conservative investment portfolio when factors completely unrelated to your holdings control their fate.

Because these contracts are not traded on an exchange or regulated, there is no way to gage how much risk any one segment of the market, say real estate, has acquired. The Obama administration is trying to remedy this by creating a new regulated derivatives exchange. But even if Obama and his administration are successful in achieving significant regulation, 75% of derivatives are traded abroad. Unless derivatives of this kind are outlawed completely they will continue to be what George Soros and Warren Buffett, two of the most successful investors of our time, call “Financial Weapons of Mass Destruction”.