To be a successful investor, you don't need a comprehensive knowledge of derivatives. But you do need a basic understanding of what can go wrong and what the danger signs are—and that's what this article is all about.
In a nutshell, derivatives are financial instruments which derive their value from some underlying asset or reference point. Consider the simple example of a wheat farmer. After taking the relevant agricultural considerations into account, he concludes that his forthcoming harvest is likely to be around 5,000 tonnes. So he enters into a contract now to deliver that tonnage of wheat to a buyer at an agreed price of $200 per tonne. Locking in the price today removes the risk of it falling below that level (as well as the benefit of it moving higher) and allows him a greater degree of certainty in preparing his budget for the year. This process is known as hedging—a phrase which, in its purest form, should be synonymous with 'removing risk'.
When settlement day arrives, the farmer doesn't usually deliver the wheat to the person on the other side of the contract. That's because that person, the 'counterparty', may well be a financial institution thousands of kilometres away. What generally happens is that an amount of money changes hands between these two parties, representing the difference between the contract price and the market price on settlement day. The farmer then takes his grain to the nearest convenient silo and receives the market price. So, if the wheat price has moved to $230 per tonne, our farmer collects $1.15m (5,000 x $230) from the Australian Wheat Board and pays $30 per tonne, or $150,000, to the counterparty of his derivative contract. His net result is $1m, or a price of $200 per tonne—the one he locked in at the start of the contract.
Visit The Intelligent Investor for the rest of this article on Dodging the derivatives bullet and to find out more on
investment definitions.