You Might Be a Derivatives Trader and Not Know It
I’m willing to bet that 50% of readers of this blog are derivatives traders and don’t even know it. A derivative is a financial security that derives its value from the value of something else. That ’something else’ could be a stock, currency, interest rate, or anything else you can think of.
There’s a lot of debate about whether the modern use of derivatives is good or bad. On the one hand, they allow an entity to minimize its risk to a specific event. For example, a company might use an interest rate swap to better plan for the future. On the other hand, derivatives are lightly- or un-regulated, and often only the two parties involved are the only ones who know about the transaction. This can amplify events in the market and arguably increases systemic risk.
You just might be trading derivatives without knowing you’re doing it. How? Common securities like Exchange Traded Funds (ETFs) are derivatives. They don’t actually own the stocks of the indexes they track. And there are mutual funds that exist solely to invest in derivatives. Rydex offers funds that match the performance of the dollar. There’s one for a strengthening dollar and one for a weakening dollar. Not only that, but these funds are actually leveraged so they match 200% of the dollar’s move up or down! [Alarm klaxon sounds]
The real point to remember with all this is that if you invest, for example, in ETFs, there is a certain, admittedly small, risk associated with them being derivatives. This is particularly true for more thinly-traded ETFs.
Finally, whether you agree or disagree with this statement about derivatives, a word from Alan Greenspan,
derivatives“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly improved national productivity growth and standards of living.”
May 30th, 2007 at 7:16 pm