T Nation

What Exactly is a Derivative?

"However, in my view, the situation is far worse this time since the US financial system is extraordinarily stretched and stressed. Last time we only had the minor bankruptcies of Franklin National Bank and Continental Bank to contend with. Then there were no derivatives. This time they amount to more than 10 times world GDP and a greater multiple of bank capital. Within that total the most toxic ones are those unlisted, opaque, over the counter variety amounting to over $50 trillion, again multiples of US bank capital.

The revolution in market finance that began with the deregulation of the 1980s may be about to eat its young, as we have seen with the putative bailouts of Fannie Mae and Freddie Mac; if nationalization goes ahead the US visible national debt increases by $5 trillion and is effectively doubled. The US would no longer qualify to join the Euro!

The US budget deficit could be on the verge of exploding upwards. Including war costs it is already over 4 percent of GDP. The economic slowdown and President Obama’s plans for healthcare, whist noble and justifiable, even after tax increases, could send the deficit north of $1 trillion or 7 percent of GDP by 2010."

http://www.marketoracle.co.uk/Article5533.html

A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.

[quote]Scrotus wrote:
A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.[/quote]

i don’t think the term is being used here in this way. The line tangent to the graph of a function for some variable doesn’t make much sense here.

[quote]stokedporcupine wrote:
Scrotus wrote:
A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.

i don’t think the term is being used here in this way. The line tangent to the graph of a function for some variable doesn’t make much sense here. [/quote]

A derivative, as I explain it to my students, is the slope of a function (elem function for them). That’s calculus.

In the financial world, a derivative is (at least to my limited understanding) a way of pyramiding a debt to increase total return. Somehow, debt can be used to create more debt and collect more interest. Its size collectively is now more than the total wealth of the world.

Maybe Doogie, Varq, or TB will join in and correct me.

A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it. The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price. This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

[quote]hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.[/quote]

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.

[quote]jchenky wrote:
hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.[/quote]

…This is why I stay in the “Get a Life” topic forums. If I keep reading posts like this, I might learn something.

[quote]jchenky wrote:
hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.[/quote]

I’ve been trying to understand the whole options thing for a while and it’s just not clicking in my head i guess.

This helped a little and made me more confused a little by saying calls and puts are more complicated…

[quote]AssOnGrass wrote:
jchenky wrote:
hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.

I’ve been trying to understand the whole options thing for a while and it’s just not clicking in my head i guess.

This helped a little and made me more confused a little by saying calls and puts are more complicated…[/quote]

I won’t go into what calls and puts are here.

I only know because i had to study this for FAR too long.

Want my books? hahah I was going to have a bon fire.

Any how if you want to learn i’m sure that your nearest library has some books on it.

[quote]AssOnGrass wrote:
jchenky wrote:
hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.

I’ve been trying to understand the whole options thing for a while and it’s just not clicking in my head i guess.

This helped a little and made me more confused a little by saying calls and puts are more complicated…[/quote]

Try trading them! You have to know the market and be able to do the math quickly and on the fly to take advantage of the trades. Mistakes cost you or your firm big.

Lot’s of fun though. Most guys can do it for a few years until your head explodes.

[quote]hedo wrote:
AssOnGrass wrote:
jchenky wrote:
hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.

I’ve been trying to understand the whole options thing for a while and it’s just not clicking in my head i guess.

This helped a little and made me more confused a little by saying calls and puts are more complicated…

Try trading them! You have to know the market and be able to do the math quickly and on the fly to take advantage of the trades. Mistakes cost you or your firm big.

Lot’s of fun though. Most guys can do it for a few years until your head explodes.
[/quote]

yeah i am definitly not a sophisticated investor, so i will not be trading them. Funny story - i took a class that looked at this whole area of the financial industry. Gentleman in the class had a family member who was not very knowledgable with derivatives and decided to trade. Needless to say he ended up having a shit load of potatoes delivered to his home.

[quote]Headhunter wrote:
stokedporcupine wrote:
Scrotus wrote:
A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.

i don’t think the term is being used here in this way. The line tangent to the graph of a function for some variable doesn’t make much sense here.

A derivative, as I explain it to my students, is the slope of a function (elem function for them). That’s calculus.
[/quote]

not to be a smart ass, but that characterization would not hold in higher dimensions. The line tangent to the graph of a function for some variable though will.

ah, but why not just talk about moments instead?

[quote]stokedporcupine wrote:
Headhunter wrote:
stokedporcupine wrote:
Scrotus wrote:
A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.

i don’t think the term is being used here in this way. The line tangent to the graph of a function for some variable doesn’t make much sense here.

A derivative, as I explain it to my students, is the slope of a function (elem function for them). That’s calculus.

not to be a smart ass, but that characterization would not hold in higher dimensions. The line tangent to the graph of a function for some variable though will.

ah, but why not just talk about moments instead?[/quote]

Because moments don’t occur until Calc III. Also, a derivative is not a line. Its a rate of change.

Arrrggghhh…this is supposed to be a thread about derivatives in financial markets, guys!! And the point WAS that derivatives are now such complicated instruments that no one will understand what’s happening when a crisis ensues, and consequently we won’t know what to do when one hits, as all capitalist systems encounter.

[quote]Headhunter wrote:
stokedporcupine wrote:
Headhunter wrote:
stokedporcupine wrote:
Scrotus wrote:
A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.

i don’t think the term is being used here in this way. The line tangent to the graph of a function for some variable doesn’t make much sense here.

A derivative, as I explain it to my students, is the slope of a function (elem function for them). That’s calculus.

not to be a smart ass, but that characterization would not hold in higher dimensions. The line tangent to the graph of a function for some variable though will.

ah, but why not just talk about moments instead?

Because moments don’t occur until Calc III. Also, a derivative is not a line. Its a rate of change.
[/quote]

i did not say i was defining it, i said i was giving a characterization of it. Your characterization that it is a rate of change also does not hold in higher dimensions (or at least, makes little sense). few characterizations hold for all applications of derivatives. the geometrical idea that it is a line tangent to the graph of a function for some variable though does.

good point

[quote]Headhunter wrote:
stokedporcupine wrote:
Headhunter wrote:
stokedporcupine wrote:
Scrotus wrote:
A derivative is a measurement of how a function changes as its imputs change, er somthin. Your supposed to be a math teacher you tell me.

i don’t think the term is being used here in this way. The line tangent to the graph of a function for some variable doesn’t make much sense here.

A derivative, as I explain it to my students, is the slope of a function (elem function for them). That’s calculus.

not to be a smart ass, but that characterization would not hold in higher dimensions. The line tangent to the graph of a function for some variable though will.

ah, but why not just talk about moments instead?

Because moments don’t occur until Calc III. Also, a derivative is not a line. Its a rate of change.

Arrrggghhh…this is supposed to be a thread about derivatives in financial markets, guys!! And the point WAS that derivatives are now such complicated instruments that no one will understand what’s happening when a crisis ensues, and consequently we won’t know what to do when one hits, as all capitalist systems encounter.

[/quote]

Oh Jesus, is it that hard?

Call option:

At x=0 you buy the right to buy Stock A at x=1 at a price at 100.

You pay 5 per share for that right.

At X=1 Stock A is traded at 110.

So you can buy A at 100, turn around, sell it for 110.

Voila, 10- 5 (the cost of the option) makes a plus of 5 per share.

The interesting thing is that while A only gained 10% the option to buy A made 100%.

Put option:

At x=0 you buy the right to sell stock A at x=1 at a price of 100.

You pay 5 per share for that right.

At X=1 stock A is traded at 90.

You buy at 90, sell at 100, you make 10 per share.

Using these instruments you can hedge against losses (also wins, but why do that), but at a price.

If I combine stock A with a put option like above you can lose 5 max.

However, if A does not gain more than 5 you only break even because you have to pay the price of the option.

The same principles are used in foreign trade to deal with exchange risks, it is called hedging.

[quote]jchenky wrote:
hedo wrote:
A derivative, in the financial world, is a transfer of risk. The value of the instrument is derived from the value of the underlying asset.

For example an option is a derivative of the underlying stock. It’s value changes on a number of variables such as the value of the stock, time left in the contract and most importantly percieved direction it will move. An option can be used to both speculate or to hedge risk. These types of derivatives have been around for years.

The derivative that is getting all the attention are credit swaps. These are complicated transactions put together by major financial firms (underwriters) who package the product and sell it.

The credit swap transfers the risk to a third party. The third party can profit based on the underlying securities value, trending and percieved direction. This is an abreviated explanation for a very complicated financial instrument.

Derivatives leverage the capital you have to invest. Choose wisely and you make a lot of money based on your invested dollars. Choose poorly and you lose it all. Many made bad decisions while attempting to raise rates of returns and are paying the price.

This is a large market primarily for professionals and institutions. The problem is these professionals often manage funds that take individual investments, pension and retirement money. Those folks are happy to accept the great returns but not the loses. Human nature.

Hedo is correct.

The underlying asset does not just have to be stocks. It can be commodities such as oil, grains, metals, cattle etc.

Derivatives can be very complicated.

Simple breakdown You and i enter into a contract today that you will buy from me some wheat. Expiration date of this contract is December 01 2008. You think that the price of wheat will go up between now and December 01 2008 and i think the price of wheat will go down.

However we agree upon a price today.
On December 01 2008, if the price of wheat increased you only have to pay the price we agreed upon on August 23rd and you save money. OR you now have the option to sell that wheat for the price it is selling at Dec 01 2008 and make money.

Usually the buyer pays a premium to the seller- this gives the buyer the right to buy the underlying and the seller the obligations of selling if you want to buy it.

So if the price of wheat decreased you do not have to buy the wheat at the price previously determined you will only be out the premium you paid and the seller is up the premium you paid him.

make sense??? hahah It gets more complicated with calls and puts.[/quote]

You explained options and futures (two different types of derivatives) but mixed them together. As far as I know there is no premium on the purchase/sale of futures. Unless you were talking about options ON futures :).

The main difference is an option gives you the right but not obligation to purchase the underlying asset.

With a future you have the obligation to purchase the underlying asset.

That is why you have to pay a premium for an option but not for a futures contract.