Derivatives; the financial weapons of mass destruction

04Oct08

If you watch CNN, Bloomberg, CNBC or any news channel that is available at your disposal, I am sure you always hear people talking about financial turmoil that is going on globally, specifically in the United States. They have been using various financial jargons to explain the situation, which is not fathomable by some viewers who do not study finance or anything related to it.

The press often uses the word derivatives nowadays. Generally, when they interview some of the financial experts about what is wrong with Wall Street? The answer is derivatives. Why did American people lose their jobs? Derivatives. Why did Lehman Brothers collapse? Derivatives. What hit AIG recently? The derivatives bomb. A few weeks ago, Warren Buffet in his exclusive conversation with Charlie Rose about the economy said that derivatives were “financial weapons of mass destruction”.

It is as if all the evils of the world are wrapped up in a single word called, DERIVATIVES. Well, what is a derivative anyway?

Here’s to my shallow and myopic understanding on derivatives which I have learnt not much in detail in my Commercial Banking and Finance subject.

Derivatives is one of the off balance sheet items. (What is off balance sheet?  Off balance sheet relates to those transactions which at the time of their origination, cannot be classified as either an asset or liability on the company’s or bank’s balance sheet.) However, I am not sure when it is amended, the derivatives positions under the latest IFRS (International Financial Reporting Standards), derivatives are now recorded on balance sheet. The underlying reason behind this is to show the performance of the derivatives. Such disclosures are needed to protect the investors, depositors (for banks) and other stakeholders. However, the fact remains that derivatives are private contracts between companies and institution. Hence, the actual performance of the derivatives can be made hidden.

A derivative, in definition, is any type of financial security, which their values depend on the market value of the underlying instruments. For example, their values may be derived from foreign exchange, gold contracts, equity contracts, commodity contracts and so forth.

There are many kinds of derivatives. We have futures, forwards, swaps, and options. I do not intend to explain all of them, but let’s take futures to enhance your knowledge on how derivatives work.

A future contract is an obligation to buy (or sell) a specified asset on a specified date at a specified price. It is an obligation, hence no choices, the holder have to exercise it. Unlike options, options give the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract, but both parties of a “futures contract” must fulfill the contract on the settlement date.

Future contract is quoted on a “price” basis. For simplicity’s sake, the future rate is calculated as 100.

Example: 90-day bill future contract

In March, Mr. A buys 20 future contracts at 8% and promises to sell them in June.  Therefore, the price is 92 per contract. (100-8=92).

In June, IF the interest rate rises at 9%, the price will reduce to 91per contract (100-9=91). Hence, Mr. A will make a loss of 1%. IF the interest rate reduces to 7%, the price will increase to 93 per contract. Hence, Mr. A will make a profit of 1%.

That is a rough idea on how futures contract work. Correct me if I am wrong.

Getting back to the topic, Brett Spur, a certified investment manager says that what makes derivatives a “bad” thing is that many derivatives can be very hard to value, because they may be based on underlying securities that are themselves hard to price, or hardly ever trade.  Firms have to rely on their own modelers to tell them what things are worth, and they sometimes get it very, very wrong.  Furthermore, banks and brokerages have been woefully negligent in keeping up with the paperwork, and may not have a full understanding of the market risk in their derivative positions, let alone the counterparty risk.

According to MarketWatch, “not only Warren Buffett, but Gross, Bernanke, the Treasury Secretary Henry Paulson and the rest of America’s leaders can’t ‘figure out’ the world’s $516 trillion derivatives.” In a nutshell, the US derivatives market is spiraling out of control now.

So, people have put the blame on derivatives. In my view, I don’t think the concept of derivatives itself is the problem. I think the PEOPLE are the problem. The rich and greedy people are the problem. They are using derivatives not to manage the risk, but as a new way to create easy money from a piece of paper.

May the rich and greedy people go to hell.

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